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Great Earnings Season! Is It Enough?

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We're approximately halfway through the earnings season, and the numbers look good. Nearly four-fifths of S&P 500 companies that have reported fourth-quarter earnings have beaten analyst estimates, including bellwethers such as Apple (Nasdaq: AAPL  ) , Goldman Sachs (NYSE: GS  ) , and Caterpillar (NYSE: CAT  ) . Better yet, almost seven in 10 companies beat revenue estimates, which means that cost-cutting is no longer the only source of profit growth. Sounds very promising. Is it the start of a trend that will push stocks higher this year?

Exceptional or repeatable?
Unfortunately, if last Friday's muted market reception to a six-year high in the gross domestic product growth rate is anything to go by, investors will take quite some convincing before they agree to push this rally onward and upward. Whether it be GDP growth or corporate earnings (which aren't unrelated), the question is whether such improvements are sustainable.

As I've written here many times, I can't understand how investors already justify paying an above-average earnings multiple for stocks -- I'm referring to the cyclically adjusted price-earnings multiple here -- in the face of risks that are without precedent in their lifetime (perhaps that's part of the problem!).

Here's another number for you
There is the shambolic state of public finances, to name but one of these risks. According to Kenneth Rogoff and Carmen Reinhart, who co-authored an exhaustive analysis of 800 years of financial crises (This Time It's Different), debt levels at or higher than 90% GDP have "historically been associated with notably lower growth." Credit ratings agency Fitch estimates that the U.S.'s ratio of public debt-to-GDP ratio will reach 94% in 2011.

On top of that, the January effect doesn't favor stock investors this year. According to Deutsche Bank strategist Jim Reid, of the 30 negative performances in January by the S&P 500 since 1928, 18 were followed by a negative returns for the full year, with an average loss of 13.75%. The S&P 500 was down 3.7% last month -- Google (Nasdaq: GOOG  ) , Microsoft (Nasdaq: MSFT  ) , and ExxonMobil (NYSE: XOM  ) were some of the largest contributors to the decline.

Thinking defensively
I'll admit I threw the January effect in as a bit of market lore -- I don't see a clear economic relationship between January and full-year returns. However, there are certainly enough fundamental problems to be concerned about that I recommend taking a defensive stance, either by underweighting the broad U.S. market or by focusing on pockets of value such as high-quality stocks.

The Fed's policies are creating a new set of tangible risks for investors. Motley Fool Global Gains co-advisor Tim Hanson explains why it's time to get out now.

If you're concerned about the threat of a long, weak recovery -- and other risks facing the economy -- focus on companies with sustainable dividend growth. The team at Motley Fool Income Investor offers six Buy First stocks, so take advantage of a 30-day free trial today.

You can follow Fool contributor Alex Dumortier on Twitter; he has no beneficial interest in any of the companies mentioned in this article. Microsoft is a Motley Fool Inside Value pick. Google is a Motley Fool Rule Breakers recommendation. Apple is a Motley Fool Stock Advisor pick. Motley Fool Options has recommended a diagonal call position on Microsoft. Try any of our Foolish newsletters today, free for 30 days. The Motley Fool has a disclosure policy.

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  • Report this Comment On April 10, 2010, at 12:53 AM, 2humble2fool wrote:

    Could somebody please introduce me to the people that buy low-quality stocks? I have some Florida swampland I think they might be interested in.

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