Are Earnings About to Collapse?

Perhaps the only bright spot in this economy has been the dazzling rebound in corporate profits. But now the Wall Street Journal says those, too, are headed south:

Analysts now expect 14.7% earnings growth for S&P 500 companies next year, according to Thomson Reuters. In April, that figure stood at about 20%; in January, it was nearly 25%. So instead of gradually gathering strength, as was expected, earnings look poised for a renewed slowdown.

Sounds scary. But I'm not so sure this analysis is logically sound.                   

The Journal seems to assume that the drop in growth forecasts means that the raw value of expected 2011 earnings is lower today than it was in January. But that's not the case. In January, analysts expected 2011 earnings of $94. Today, the average estimate is for $96.

How can the expected growth rate decline while the expected raw value rises? Because the base number we're comparing 2011's growth with -- 2010 expected earnings -- has grown since January. Back then, analysts expected 2010 earnings of $77.59. Today, with more than half the year behind us, the average 2010 estimate is $82.

So the decline in 2011's expected growth rate has almost nothing to do with 2011's actual earnings. It's a factor of analysts expecting higher earnings in 2010.

And that's somehow bad news? I don't see how it is.

Focus on valuations
Here's another, more meaningful, way to view this issue:

Source: Capital IQ, a division of Standard & Poor's.

Whether analysts are raising or lowering earnings forecasts is relatively meaningless for investors. What's important is how those forecasts stack up in relation to market prices. Here, the trend over the past year is clear: In relation to forward-looking estimates, the market has been getting consistently cheaper. Again, this is not bad news.

The risk, of course, is that analysts will end up being horribly wrong, with actual earnings coming in well below consensus estimates. This is an especially high risk today, because we're at a crossroads in the economy, fighting between recovery and a possible double-dip. When the future is that far up in the air, analyst estimates have a tendency to be horribly wrong more often than not.

The appropriate way to circumvent this dilemma is to pick companies where the valuation is so compelling in relation to forward earnings estimates that, even if the estimates end up being wholly wrong, the stock would still probably be a good value. Plenty of stocks fit this bill:

Source: Capital IQ, a division of Standard & Poor's.

Cheap today, cheap tomorrow
For all these companies, analysts' forward-looking earnings estimates can be way off, by maybe as much as 50%, and the stocks would still be a decent value at today's prices. This is true for many companies today, particularly large-cap stocks. Valuations seem to be pricing in a depression-like event that seems unlikely (though certainly not impossible).

Even if analysts were slashing earnings forecasts -- and by and large, they're not -- the odds still seem stacked in favor of investors choosing solid, large-cap stocks over bonds and cash. This is exactly what you should be looking for in environment: a margin of safety. That's when investing gets fun.