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Will Strong Corporate Earnings Hold Up Since the Downgrade?

Company earnings have been a bright growth spot in this otherwise subpar economic recovery. But can these corporate earnings hold up?

This is one of the key questions being asked by stock investors these days. Portfolio Manager Matt Freund talks about this week’s market activity.

By Matt Freund

Earnings per share for the S&P 500 stock index are estimated to be roughly $99 for 2011 and $110 for 2012, with annual increases of 9% and 12% respectively, according to the average estimates of Wall Street strategists.

Although we, like many forecasters, are skeptical that 12% earnings growth next year can be achieved in light of weak economic growth, we believe that at current valuations (S&P 500 index is at 12 times earnings and foreign markets are even lower), there is room to reduce future growth expectations without adversely affecting prices. In other words, we think stocks have already priced in a weak earnings growth outlook.

Since the U.S. debt downgrade in early August, the S&P 500 has remained in a 100-point trading range between 1,120 and 1,220, with volatile swings fueled largely by the uncertainty of the European debt crisis, the anticipation of the Fed’s monetary actions and growing fears of a recession.

Stocks struggled to make a gain this week, as a key vote in Germany to approve yet another financial aid package to Greece was well received. The S&P 500 closed at 1,131.42, down 0.44% on the week. Following a drop to record-low yields last week, U.S. Treasury bonds sold off this week, with the yield on the 10-year rising by 0.07% to close at 1.91%. Gold fell by 1.98% on the week to close at $1,623.97 per ounce

This week’s domestic economic news was generally encouraging, and confirms our view that we are in a slow-growth recovery. Highlights included the release of second-quarter gross domestic product, which increased by 1.3%, slightly higher than expected, and a drop in weekly initial jobless claims to 391,000, lower than expected.

Our long-term outlook for the world economy continues to be one of below-average growth, with the risk of inflation on the rise. Our asset allocation in our diversified managed portfolios remains overweight U.S. large-cap stocks, high-yield bonds and precious metals. We continue to maintain an underweight in foreign stocks and investment-grade bonds.

Next week’s key economic releases:

• Motor vehicle sales
• Employment report
• Unemployment rate
• Institute for Supply Management Manufacturing Index
• ISM Non-manufacturing Index

Text version:

Matt Freund: It has been an interesting month. Over the last month, the markets have really been struggling with two big questions. The first one coming from Europe, and again, the markets are looking for, hoping for, a long-term solution to what we’re seeing in weaker countries like Greece, Spain, Portugal and how they’re going to get out of their debt problems. So that’s the first big worry for the markets that they’re struggling with. The second one is just the economy overall. So we’ve been coming out of a balance sheet recession, there’s been a lot of leveraging … had people paying down debt, and this on again off again growth, the fact that growth has been very tepid, much lower than we had hoped for, or even expected, going back to the beginning of the year and the markets have really struggled with that in August, and now in September.

Investors are often faced with the question of: “There is volatility in the market and what should we do?” and our advice is to stick with your investment horizon. Most folks don’t know or are surprised to see the stocks are actually up as we’re talking, almost 3.5% from a year ago. Now that’s a lot less than say, in May and June, but it’s still significantly higher than what you would get in money markets. So if you are patient, if you have a longer-term horizon, the fact that stocks are down actually makes them more attractive going forward, meaning the valuations are lower than they were just a couple of months ago.

So it comes down to your time horizon, if you are looking for short-term gains, [it's a] much harder call, but for the long term we’re still on board that stocks are fairly decent advisor, fairly attractive, more attractive than they were several months ago. Twenty-five years ago is too long, so when we talk about what an investor’s horizon should be in more volatile classes, again I think 12 months is clearly too short, safely I would say you have to consider equity for that portion of your portfolio that you don’t plan to access for the next three to five years at a minimum.

So the roadmap for the 4th quarter, the markets are really struggling with the points we’ve mentioned earlier so with Europe we expect more of the same, there are no quick solutions. We think there’s going to be a lot of headlines, but again we don’t see any easy answers and this is something Europe is going to be struggling through, so volatility there continues. With the economy, we’re coming out of a balance sheet recession, on-again, off-again growth is fairly typical. We don’t currently expect to see significant weakness but even modest growth isn’t going to feel very good. The Fed, they instituted their Operation Twist, long rates came down and that’s very supportive.

So the markets looking forward to the next three months, they’re going to start digesting 2012 earnings. If we don’t get a recession, we expect those earnings to come well north of $100, $105, $110 which is fairly constructive for stocks. If we do see economic weakness those estimates could come down significantly, 15, 20, 25% which would makes stock a little vulnerable and that’s what the market is going to be struggling with over the next couple of months.

This material is for informational purposes and is not investment advice, an indicator of future performance, a solicitation, an offer to buy or sell, or a recommendation for any security. It should not be used as a primary basis for making investment decisions. Consider your own financial circumstances and goals carefully before investing.

Past performance is no guarantee of future results. Investing in securities products involves risk, including possible loss of principal. Foreign investing is subject to additional risks, such as currency fluctuations, market illiquidity, and political instability. Investments provided by USAA Investment Management Company and USAA Financial Advisors Inc., both registered broker dealers.

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