As we have mentioned a few times in previous updates, the stock markets typically follow earnings. Stock valuations are based on cash flows and earnings so it makes sense that when earnings increase stocks move higher and vice versa. We stated in our mid-year update a few weeks ago that the economy is secondary to earnings and in the long run earnings are what drive stock valuations. Focusing on statistics and earnings estimates also helps remove emotion from the decision making process.
Last year earnings fell about 40% from the results posted in 2007 and the stock market (based on the S&P 500) declined roughly 40%. Earlier this year the stock market dropped about 20% based on expectations of a significant drop in earnings for 2009. When earnings estimates stabilized and expectations for a recovery in the second half of this year began to take hold, the stock markets increased in anticipation.
However, we recently reviewed the current estimates for the S&P 500 for 2009 and noticed earnings estimates have actually declined (as of August 5th) as the stock markets have moved materially higher. Roughly a month ago, earning estimates for 2009 were starting to increase. Earnings estimates increased from roughly $55 to roughly $56 per our mid year update. As of August 5th, estimates for 2009 have actually declined - yes, declined - from $56 to $54.28 and estimates for 2010 have declined from over $76 to $73.18. This decline is on the heels of many companies reporting better than expect earnings for the quarter and many analysts revising earnings estimates for the balance of the year.
So as the markets move higher, earnings estimates decline. It could be that estimates have not been updated and earnings estimates will move higher in the coming weeks. However, this is not likely as these estimates are updated weekly on Standard and Poor's website. In the end something will need to change. Either the stock market declines to better reflect lower earnings or earnings estimates increase markedly to help support current valuations, which continue to increase by the day. While anything is possible and we will continue to watch estimates, we could be setting up for another interesting 4th quarter.
