It's Time for "Show Me the Money"

This week ushered in the beginning of “show time” for the stock market in the form of earnings reporting season. On Thursday aluminum producer and Dow component Alcoa kicked off the show when it reported its second quarter profit results. Stock markets rise and fall for innumerable reasons, but in the end stock values as a whole are linked to corporate profitability above all else. Recent performance indicates that the rally that raised stock indexes almost 40% from their March is taking a break, but most strategists attributed the rally to two primary factors. The first factor was the belief that the worst of the financial crisis was behind us. With the government taking unprecedented actions to stabilize the financial system investors apparently felt Armageddon had been averted and in this context stocks looked to present a buying opportunity. But the less dramatic story was probably the more important. And the less dramatic story was that corporate profits in the first quarter, while dismal, were really not quite as bad as Wall Street expected. So the market rallied. But stocks cannot rally in a vacuum, and ultimately real profits must support stock prices. The most basic and undoubtedly important measure of stock prices is the price of a stock divided by the per share profits of the company the stock represents, this is known as the price to earnings ratio (P/E ratio). Stock market indexes can also have an average price to earnings ratio based upon all the stocks that make up the index. The S&P 500 has historically traded at a price to earnings ratio between roughly 12 and 20, with ratios above 15 historically being considered to fully valued or if looked at in a vacuum, fairly neutral. It is interesting to note that the S&P 500 currently has a P/E ratio of 16, which perhaps incidentally is the same level the index was at near the market top in late 2007. The reason the index can be at the same ratio when the value of the index remains roughly 40% lower is that corporate profits have contracted by roughly the same percentage. An index P/E ratio of 16 does not by itself provide a lot of guidance, but many strategists would say that a P/E at that level would be more indicative of a market top than an opportunity. So this begs the question, if stocks are fairly valued what would it take to restart the rally? The answer is earnings. If earnings reported in the next few weeks are higher than last quarter, the market may track earnings at their current P/E ratio and go higher. Or if earnings don’t actually rise, but come in better than expected the average P/E ratio could actually go higher as investors express confidence that the recession is abating. But reality is that expectations for earnings are pretty low, so investors may in the end decide to disregard current news that is expected to be bad and attempt to read between the lines. When companies report their profits they will also release analysis of their sales and operations. Investors will be combing these releases for signs of light at the end of the tunnel. It is my expectation that the next few weeks will be quite volatile because earnings and guidance will provide no clear or coherent conclusion for investors. And in this spirit we are back to Alcoa, who presented better than expected numbers in the form of a smaller loss than anticipated. It might be easier to read tea leaves.