Richard E. Haskell, Sr.
April 6, 2010 Edition, Volume IV
Inside Signature Update
• The Market – Earnings Expectations and Tobin’s Q
• The Economy – Is a “Double Dip” off the Table?
• The Takeaway – There’s More to Come
THE MARKET – Earnings Expectations and Tobin’s Q
Market earnings expectations and ratios
As the DOW approaches the 11,000 point mark, market observers begin to wonder just how far the index can climb before the market becomes overvalued. It’s a difficult question to answer and has everything to do with corporate earnings and how investors value the future earnings potential of firms as the economy recovers.
The 11,000 point mark on the DOW is less of a technical benchmark than it is an emotional one; the S&P 500 is another story. The S&P closed Monday, April 5th at 1187, only 13 points shy of the important 1,200 point level. For the S&P to sustain itself beyond the 1,200 point
level, the market will need to see increased corporate earnings.
The index’s current P/E ratio (price to earnings ratio) sits at 21.7 – meaning that for every dollar of earnings there is $21.70 of index value. That may seem high, but when compared to forward earnings expectations the ratio drops dramatically.
Market analysts expect to see aggregate, per-share earnings for those stocks comprising the index of $83-$85 for 2010 and $90 for 2011; compared to current earnings of $51.74 for 2009. Based on the current earnings ratio of 21.7, these earnings estimates, if reached, would indicate the S&P at a lofty 1,800 by the end of 2010.
Perhaps a more realistic expectation is based on the index’s mean (average) ratio of 15.73, which would indicate the S&P 500 index at 1,305. This represents an increase of 10% from current levels and falls directly in line with our 2010 estimates for the domestic equities markets.
Earnings Reports and Tobin’s Q
In the coming weeks publically held corporations will begin to release 1st Quarter 2010 earnings reports. Some investors and observers find themselves confused as to why some stocks will post gains in the face of strong earnings, while others might decline: the answer lies within Tobin’s Q.
In 1969, Nobel prize winning economist, Dr. James Tobin (Yale University) challenged the traditional theory that investments were valued as a function of economic interest rates and proposed an alternate valuation model that became known as Tobin’s Q. Tobin’s model suggests that investment values are based on how investors value a firm’s business plan, expected earnings, potential political and economic developments, and the replacement cost of the investment. It presumes that the market has full knowledge of those issues impacting a firm (transparency) and is predicated on a liquid market for the investment (publicly traded stock, etc.).
The issues of supply and demand, business cycles, global markets, etc. weren’t included in valuation models before Tobin published his theory, and most investors were simply left with P/E ratio and dividend yields when attempting to make good investment decisions. Based on Tobin’s theory and the complex mathematical formulas he developed to model it, market values rise and fall based on the aggregate affect of these factors, rather than simply on changing economic interest rates. While most investors won’t apply available data to the model, there’s sufficient recognition in the markets of those factors impacting values that the model is used implicitly to support price levels and predict future valuations.
When a company announces earnings estimates, the value of their shares change in direct relation to how the estimates compared with analyst expectations. Similarly, when earnings are reported, the actual is compared to estimates and expectations and share values may adjust accordingly. If good earnings are already expected, the share price has already risen to meet the expectation, and once actual earnings are reported the share value will only change if actual results differ from those anticipated.
When firms report their earnings, they normally update the firm’s guidance, or expected performance, against their business plan. This can also impact share values as investor and analyst expectations are heavily based on a firm’s guidance; if the firm has a track record of accuracy and reliability. For those firms that have a poor track record when it comes to meeting the expectations their own leadership cultivated, the market will rarely respond to a new set of optimistic expectations, but will react sharply to negative guidance.
Ready availability of information and a liquid market
The key to Tobin’s valuation concepts and to how today’s investors and markets value investments lies in the ready availability of information and a liquid market. Since Tobin formulated his theories these market elements have improved dramatically and market valuations have become more statistically significant than at any time in history. Likewise, expectations for earnings growth, though becoming more optimistic than in recent months, have solid foundations and are based more on observed trends than anticipation and hope.
THE ECONOMY – Is a “Double Dip” off the Table?
Mounting evidence and some optimistic expectations
There’s mounting evidence that the economy will continue to grow at a 3% to 5% pace for 2010; with some expectations reaching as high as 6% based on March 2010 economic activity reports. Factory orders and retail sales continue to make important gains and the labor market is just beginning to see the first signs of meaningful improvement. Inventory levels reflect demand-driven patterns as manufacturing increases and wholesale orders are only barely outpacing consumer demand. There is now enough upward momentum that many economists believe the US is no longer in danger of a “double dip” recession.
Perhaps the most important sign of real growth comes from the Federal Reserve itself. The Fed’s February 18th increase of the discount rate to .75% and other recent comments by Fed policy makers point to the agency’s firming belief that the US economy is approaching the point at which it will be able to sustain a broad-based rate increase.
Market reactions to higher rates
While the immediate stock market response of such an increase will most likely be negative, the longer term reaction will almost certainly be strong and to the upside; as investors accept that the Fed is committed to only raising rates in the presence of economic strength. The current 0%-1/4% Fed Funds target is so low that investors have little incentive to invest in interest bearing or dividend yielding instruments. As the rate environment shifts to more sustainable levels, investors will come back to the markets yet more aggressively than already experienced; first to bonds and then to stocks, as long as targets don’t rise above 3%-4%. As a result, the capital markets, so critical to business lending and capital formation, will open up and funds needed for growth will be widely available for the first time in years.
The bond markets will certainly respond negatively to rising rates, due to the inverse relationship between rates and bond prices. Higher interest rates also drive the dollar higher and as a result, commodities prices for agricultural products, precious metals and oil will rise in response to higher rates. The aggressiveness of rate increases will reflect the Fed’s concern over possible inflation. Moderated increases of ¼ to ½ point per announcement will suggest the Fed is simply trying to react to a stabilizing market; while aggressive increases of ¾ point or more are likely to signal the Fed moving into inflation fighting mode.
Federal Reserve Chairman Bernanke and other Fed Governors have already stated that when rate increases begin they’re likely to be meaningful. Though this may have been in response to inflation concerns, the markets will breathe a sigh of relief when the time comes. This is one of those issues that the market recognizes must be faced in order for the economy to move past the recovery stage and into longer-term growth. Once the announcements are made and the market digests the material impact, the mounting anticipation will likely give way to higher equity values and real post-recession growth.
THE TAKEAWAY – There’s More to Come
• The DOW is poised to cross the 11,000 point mark at any time, and will likely climb higher in coming months. Though interim corrections of 5%-7% will occur, market levels should rise with corporate earnings through the end of the year.
• The much anticipated “Double Dip” for the US economy appears to be highly unlikely based on economic reports and rising expectations. Further weakness in the real estate and employment markets could spell trouble, but most analysts expect the danger has passed.
• The Fed’s interest rate position remains unchanged, but small “adjustments” are being made and setting the stage for economically healthier rates in the future.
Signature Update is offered by Richard Haskell, Managing Director of Signature Wealth Management and CEO of Signature Management, LLC
April 6, 2010 Edition, Volume IV
Inside Signature Update
• The Market – Earnings Expectations and Tobin’s Q
• The Economy – Is a “Double Dip” off the Table?
• The Takeaway – There’s More to Come
THE MARKET – Earnings Expectations and Tobin’s Q
Market earnings expectations and ratios
As the DOW approaches the 11,000 point mark, market observers begin to wonder just how far the index can climb before the market becomes overvalued. It’s a difficult question to answer and has everything to do with corporate earnings and how investors value the future earnings potential of firms as the economy recovers.
The 11,000 point mark on the DOW is less of a technical benchmark than it is an emotional one; the S&P 500 is another story. The S&P closed Monday, April 5th at 1187, only 13 points shy of the important 1,200 point level. For the S&P to sustain itself beyond the 1,200 point
level, the market will need to see increased corporate earnings.The index’s current P/E ratio (price to earnings ratio) sits at 21.7 – meaning that for every dollar of earnings there is $21.70 of index value. That may seem high, but when compared to forward earnings expectations the ratio drops dramatically.
Market analysts expect to see aggregate, per-share earnings for those stocks comprising the index of $83-$85 for 2010 and $90 for 2011; compared to current earnings of $51.74 for 2009. Based on the current earnings ratio of 21.7, these earnings estimates, if reached, would indicate the S&P at a lofty 1,800 by the end of 2010.
Perhaps a more realistic expectation is based on the index’s mean (average) ratio of 15.73, which would indicate the S&P 500 index at 1,305. This represents an increase of 10% from current levels and falls directly in line with our 2010 estimates for the domestic equities markets.
Earnings Reports and Tobin’s Q
In the coming weeks publically held corporations will begin to release 1st Quarter 2010 earnings reports. Some investors and observers find themselves confused as to why some stocks will post gains in the face of strong earnings, while others might decline: the answer lies within Tobin’s Q.
In 1969, Nobel prize winning economist, Dr. James Tobin (Yale University) challenged the traditional theory that investments were valued as a function of economic interest rates and proposed an alternate valuation model that became known as Tobin’s Q. Tobin’s model suggests that investment values are based on how investors value a firm’s business plan, expected earnings, potential political and economic developments, and the replacement cost of the investment. It presumes that the market has full knowledge of those issues impacting a firm (transparency) and is predicated on a liquid market for the investment (publicly traded stock, etc.).
The issues of supply and demand, business cycles, global markets, etc. weren’t included in valuation models before Tobin published his theory, and most investors were simply left with P/E ratio and dividend yields when attempting to make good investment decisions. Based on Tobin’s theory and the complex mathematical formulas he developed to model it, market values rise and fall based on the aggregate affect of these factors, rather than simply on changing economic interest rates. While most investors won’t apply available data to the model, there’s sufficient recognition in the markets of those factors impacting values that the model is used implicitly to support price levels and predict future valuations.
When a company announces earnings estimates, the value of their shares change in direct relation to how the estimates compared with analyst expectations. Similarly, when earnings are reported, the actual is compared to estimates and expectations and share values may adjust accordingly. If good earnings are already expected, the share price has already risen to meet the expectation, and once actual earnings are reported the share value will only change if actual results differ from those anticipated.
When firms report their earnings, they normally update the firm’s guidance, or expected performance, against their business plan. This can also impact share values as investor and analyst expectations are heavily based on a firm’s guidance; if the firm has a track record of accuracy and reliability. For those firms that have a poor track record when it comes to meeting the expectations their own leadership cultivated, the market will rarely respond to a new set of optimistic expectations, but will react sharply to negative guidance.
Ready availability of information and a liquid market
The key to Tobin’s valuation concepts and to how today’s investors and markets value investments lies in the ready availability of information and a liquid market. Since Tobin formulated his theories these market elements have improved dramatically and market valuations have become more statistically significant than at any time in history. Likewise, expectations for earnings growth, though becoming more optimistic than in recent months, have solid foundations and are based more on observed trends than anticipation and hope.
THE ECONOMY – Is a “Double Dip” off the Table?
Mounting evidence and some optimistic expectations
There’s mounting evidence that the economy will continue to grow at a 3% to 5% pace for 2010; with some expectations reaching as high as 6% based on March 2010 economic activity reports. Factory orders and retail sales continue to make important gains and the labor market is just beginning to see the first signs of meaningful improvement. Inventory levels reflect demand-driven patterns as manufacturing increases and wholesale orders are only barely outpacing consumer demand. There is now enough upward momentum that many economists believe the US is no longer in danger of a “double dip” recession.
Perhaps the most important sign of real growth comes from the Federal Reserve itself. The Fed’s February 18th increase of the discount rate to .75% and other recent comments by Fed policy makers point to the agency’s firming belief that the US economy is approaching the point at which it will be able to sustain a broad-based rate increase.
Market reactions to higher rates
While the immediate stock market response of such an increase will most likely be negative, the longer term reaction will almost certainly be strong and to the upside; as investors accept that the Fed is committed to only raising rates in the presence of economic strength. The current 0%-1/4% Fed Funds target is so low that investors have little incentive to invest in interest bearing or dividend yielding instruments. As the rate environment shifts to more sustainable levels, investors will come back to the markets yet more aggressively than already experienced; first to bonds and then to stocks, as long as targets don’t rise above 3%-4%. As a result, the capital markets, so critical to business lending and capital formation, will open up and funds needed for growth will be widely available for the first time in years.
The bond markets will certainly respond negatively to rising rates, due to the inverse relationship between rates and bond prices. Higher interest rates also drive the dollar higher and as a result, commodities prices for agricultural products, precious metals and oil will rise in response to higher rates. The aggressiveness of rate increases will reflect the Fed’s concern over possible inflation. Moderated increases of ¼ to ½ point per announcement will suggest the Fed is simply trying to react to a stabilizing market; while aggressive increases of ¾ point or more are likely to signal the Fed moving into inflation fighting mode.
Federal Reserve Chairman Bernanke and other Fed Governors have already stated that when rate increases begin they’re likely to be meaningful. Though this may have been in response to inflation concerns, the markets will breathe a sigh of relief when the time comes. This is one of those issues that the market recognizes must be faced in order for the economy to move past the recovery stage and into longer-term growth. Once the announcements are made and the market digests the material impact, the mounting anticipation will likely give way to higher equity values and real post-recession growth.
THE TAKEAWAY – There’s More to Come
• The DOW is poised to cross the 11,000 point mark at any time, and will likely climb higher in coming months. Though interim corrections of 5%-7% will occur, market levels should rise with corporate earnings through the end of the year.
• The much anticipated “Double Dip” for the US economy appears to be highly unlikely based on economic reports and rising expectations. Further weakness in the real estate and employment markets could spell trouble, but most analysts expect the danger has passed.
• The Fed’s interest rate position remains unchanged, but small “adjustments” are being made and setting the stage for economically healthier rates in the future.
Signature Update is offered by Richard Haskell, Managing Director of Signature Wealth Management and CEO of Signature Management, LLC
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