The Other Recession Getting Priced into the Market


There's a lot of talk about whether or not stocks are cheap, or are simply (fairly?) reflecting headwinds in the face of great economic uncertainty here and abroad. While the natural cycle of corporate profits leads to slower and slower growth rates, to track the trend is, at least, telling.

Take a look at the most recent S&P 500 earnings growth rates, according to FactSet:

+30% in Q4 of 2010

+19% in Q1 of 2011

+11% in Q2 of 2011

And Q3 2011 is targeted to grow 12%. This trend matters, because it ultimately drives valuation of the market.

"I think it is entirely possible that we have an earnings recession," says Clark Yingst, the chief market analyst at Joseph Gunnar. By his outlook it's already underway, and this call is not dependent upon the U.S., Europe, or the global economy actually falling into textbook recession --two consecutive quarters of negative growth-- themselves.

"I would say stocks today are cheap but not as cheap as they appear to be," says Yingst. And that is the crux of the trillion dollar question right now.

While FactSet data will show that, on a forward P/E ratio basis, stocks are currently trading about 25% cheaper than their 10-year average right now (at 11.4x vs 14.9x estimated earnings), investors are hardly rushing in to take advantage of the "sale". Yingst says that reluctance to dive in stems from the historical fact that analysts tend to underestimate earnings when they are trending up and also when they are trending down.

"You hear from the bullish camp how cheap stocks are," Yingst says in the attached video clip. "The same representatives of that camp were telling you how cheap they were at the recent peak."

And he has similar concerns about the trend in profit margins, which have been pushed to record levels, not due to massive revenue growth, but rather steep operational cost cuts, better known as layoffs. So with the "easy" cost reductions already taken, he says there's only one direction that margins can ultimately go from here; lower.

Just something to think about the next time someone tries to entice you with talk of "cheap stocks" and low P/E ratios.

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