Monday, May 04, 2009

Stocks: Climbing a Wall of Worry

With first quarter earnings for the S&P 500 now expected to be down nearly 34%, it is a fair question to ask why the stock market has been so excited recently? There are many answers but the simplest one is that when the first quarter earnings season began, earnings were expected to be down nearly 39%. It appears that the market has translated the 5% better-than-expected earnings growth into a 13% move in stock prices. At first that may not add up. How does a 5% earnings surprise translate into a 13% price hike? Actually, the nominal difference between negative 39% and 34% is 5%, but on a percentage basis, it is 12.8% (5/39). So stocks have rallied by about the amount of their better-than-expected earnings. That would almost seem to be too perfect. Surely there have been other factors driving stocks higher in recent weeks? There has been some isolated good news in real estate, durable goods, and more recently in a slowing of initial unemployment claims, but I believe the main driver of the recent market rally is the better-than-expected earnings for the first quarter. The market apparently now believes that first quarter 2009 earnings are as bad on a year-over-year basis as we are likely to see. According to Bloomberg, for companies in the S&P 500 that have reported thus far, there have been 236 positive surprises and 111 negative surprises. That may sound impressive until you realize that positive surprises usually outnumber negative surprises by about this margin. I believe the earnings data point that is driving the recent surge in stock prices is the higher than normal average surprise of 12%. Importantly, the financials have produced an average positive surprise of 36%. Almost all of the big banks have reported earnings that were better than expected. These results have been cussed and discussed, but in this very tough environment when the accountants are tougher than waterfront cops, the banks appear to be doing better than most people expected. That, my friends, is cause for a modest rally in stocks. Now many of you will say that there is still lots of bad news coming for the banks and that this quarter's earnings were a case of financial engineering. In addition, the stress test results will be released later this week, which could cause all of the positive momentum for the banks to evaporate. I believe the markets have discounted these issues. The recent sharp rally in bank stocks is clearly signalling that the need for additional capital resulting from the stress tests is expected to be manageable and won't result in widespread nationalization of the banks, as was feared only a few months ago. We have been saying for the last couple of months that the market was bottoming. There are many who are saying the rally can't last. We continue to believe that this rally is for real. It won't continue straight up, but we believe it will continue to climb a wall of worry.