Corporate Earnings Analysis

Despite dour earnings announcements of late, the stock market is setting up for a massive rally into the close of the year.

As the second quarter earnings season approaches, it is once again time to confabulate the facts surrounding market fundamentals. Firstly one cannot help but recognize the dreary pre-announcement and early earnings results.

Last week we witnessed a slew of negative earnings announcements. A few striking disclosures within the technology sector has investors scrambling for the exits.

Red Hat (RHT), the provider of open source software solutions ended Thursday with losses over 6% as the company issued a weak outlook for the second quarter. Second quarter revenues are expected to come in between $320 and $322 million, with adjusted earnings per share coming in at $0.28-$0.29, as earnings are impacted by a slowdown in Europe and Japan.

Micron Technology (MU), the manufacturer of semiconductor devices fell almost 8% in Thursday's trading session, as investors note that demand for flash sales have been strong, up 40% on the year, but revenues increased at a much slower pace amidst steep price declines.

Adobe Systems (ADBE) late Tuesday posted results that beat Wall Street's targets, but the maker of graphic design software trimmed its outlook for the current quarter and year, citing weaker demand in Europe.

The bad news is also affecting those companies that are considered economically defensive.

Philip Morris International (PM) warned on its full year outlook for the second time in two months on Thursday. The maker of Marlboro and Parliament branded cigarettes now expect full year EPS of $5.10-$5.20, well below analyst expectations of $5.23. It cited currency rates and weaker European demand.

Procter & Gamble (PG) was focused on investing in China and other developing nations in a effort to offset stagnate growth in Europe and other developed nations. But the maker of Tide detergent and Cover Girl cosmetics lowered its sales and profit guidance on Wednesday due to unfavorable exchange rates.

Food, beverage and retailers also suffered.

PepsiCo (PEP) warned on 2012 profit due to unfavorable exchange rates.

Darden Restaurants (DRI) reported fourth-quarter sales below Wall Street estimates as promotions at its Olive Garden chain fell flat.

Bed Bath & Beyond (BBBY) fell 17% in giant turnover. Late Wednesday, the home goods retailer said first-quarter earnings rose 24% to 89 cents, a nickel above forecasts. But a 5% gain in revenue to $2.22 billion fell just short of expectations. The company put Q2 EPS between 91 cents and $1.03, below forecasts for $1.08.

Additionally, the all-important transportation sector, that tracks closely to the health of the U.S. economy offered up some grim forecasts.

FedEx (FDX) the world's second largest delivery service delivered disappointing results Tuesday morning for its fiscal fourth quarter, missing revenue targets and projecting first quarter profit well below analyst forecasts.

Ryder Systems (R) sees Q1 EPS of 55-58 cents, well below analysts’ views for 69 cents.

Short-term data mining

While it is certainly important to track the quarterly earnings for the largest corporations in the world, one needs to reject much of the noise inherent in these projections.

To address corporate earnings, the market is very forward thinking in its digestion of corporate earnings outlook. There has been little correlation between annual earnings grow for the S&P 500 and market returns. According to research produced by Doug Ramsey at Leuthold Group, of “the 16 best years for stocks, eight actually coincided with declines in corporate earnings. And profits rose in 13 of the 16 worst years for stocks.” Tables Have Turned for Corporate Earnings and Stocks – Paul J. Lim – New York Times. It is for this reason that we at JSK Partners tend to ignore the month-to-month and quarter-to-quarter changes in earnings projections and focus on the forward twelve months of earnings expectations.

What to expect from corporate profits.

We have seen a very dramatic improvement in the corporate earnings picture since the start of the year. As of last Friday, analysts are forecasting $111.00 for the S&P 500 in the coming twelve months. That’s up from mid-$106’s at the start of the year.

This increase in the twelve month forward earnings per share forecast is very encouraging in light of market valuations. Given Friday’s close of $1335, the twelve month forward P/E ratio stands at 12.0x. This stands in stark contrast with the seventeen year historical average of 14.9x, the trailing ten year average of 14.3x and the trailing five year average of 12.9x.

Using these historical valuation measures, one would place a twelve month price target for the S&P 500 within a range of $1437 to $1660, some 7.5% to 24% higher, respectively. Using an average valuation, we are placing a fair value target on the S&P 500 of $1562 or 17% higher than Friday’s close.

Why the market is going to rally 20% starting in the second half of the year.

Fundamentally, the US stock market is undervalued and quickly approaching a buy point that will start a long-term rally. We are confidently making this call based on the fundamental research we have calculated and analyzed.

Our fundamental model encompasses several valuation metrics in an attempt to arrive at a fair value for the US indices. The key elements within our fundamental model focus on:

1 - The twelve-month forward earnings yield for the S&P 500 (which is the inverse of the twelve-month forward P/E ratio).

2 - Expected earnings growth over the coming twelve months.

3 - Yield differential against the ten-year treasury yield to attempt to capture security rotation.

We have been tracking this model for over fifteen years and it has produced significant market directional opportunities. Unlike our behavioral model that seeks out more shorter-term directional movements in order to capitalize on excess returns through tactical portfolio rebalancing, our fundamental model provides information on larger secular shifts in the US equity markets and directs our strategic positioning.

When interpreting the fundamental model, one needs to wait for the trigger line (thin blue line) to fall below zero and buy when the trend line (thick orange line) starts to head higher.

As can be seen we are below the zero line and the trigger line has turned higher. This puts us on alert that we are approaching market bottoms and will increase our long exposure more aggressively when the trend line heads higher.

When following these rules of engagement, our fundamental model has picked points in the market when the US equity indices have gone on to return 28% on average in the following year.

We are extremely energized by the opportunity the market will offer us once we have confirmation in the fundamental model. Our anticipation is that this pending rally will happen sometime in the second half of this year.

Joseph S. Kalinowski, CFA