Why Stocks, Earnings Take Different Paths

If the question is what killed the bull market, one suspect can be dismissed: We know it wasn’t lousy earnings.

More than 1,300 companies have already reported their second-quarter results, and 71% of those firms met or exceeded Wall Street’s expectations, according to earnings-tracker Zacks Investment Research in Chicago.

That’s the highest percentage of on-target-or-better quarterly earnings in the nine years Zacks has kept data, says Zacks chief Ben Zacks. In the first quarter, by contrast, about 61% of firms’ earnings met or topped expectations, he says.

Yet on Wall Street, the reaction to the second quarter’s excellent numbers has been tepid at best, outside of a few individual earnings-induced rallies--IBM Corp.’s surge last week among them.

True, the Standard & Poor’s 500-stock index has risen 2% since earnings season began on July 1, but that has just been enough to pull the index back up to its mid-June level. Year-to-date the S&P; is down 2.9%.

For investors, this combination--earnings momentum without stock price momentum--is frustrating at best and demoralizing at worst. Aren’t stocks and earnings supposed to move in tandem?

Often, they do. In 1990, earnings went down and so did stocks. In 1991, earnings went down again, but stocks went up because investors bet that an economic recovery was near. In 1992 and 1993 the recovery came, and earnings and stocks rose together.

This year, Wall Street analysts are estimating that operating earnings (i.e., earnings before one-time charges or gains) will rise 16% for the S&P; 500 companies as a group, Zacks says. And in 1995, the analysts see another year of earnings growth, albeit at a slower pace--about 13.5%, according to Zacks.

The problem, of course, is that the same economic expansion that is lifting earnings is also lifting interest rates. So far this year, the shock of rising rates--and fear of still-higher rates in 1995--has been a powerful depressant on stock prices. Earnings look good, but the market can’t overcome its paranoia about rates.

That concern isn’t baseless. Take auto stocks, for example: Though earnings at the Big Three are surging this year, the market is already focused on 1995. If interest rates continue to rise, at some point in 1995 or 1996 the current auto sales boom will probably go bust.

So Wall Street is pricing auto stocks not on hot 1994 earnings, but on the expected lower earnings in the not-too-distant future.

“People are already looking at the cyclical peak in earnings for some of the economy-sensitive industries,” says David Klassen, co-manager of the Vista Capital Growth fund and Vista Growth & Income fund in New York.

Meanwhile, even stocks of companies whose earnings growth is expected to be steady over the next few years, rather than cyclical, have been depressed by interest rate worries. Wall Street’s approach is simple and logical: If interest rates are up, stocks aren’t worth as much as when rates are down. Investors lower the prices they’re willing to pay relative to earnings per share.

In market jargon, price-to-earnings “compression” is occurring. As earnings get better but stock prices hold steady or fall, the market’s price-to-earnings ratio, or P-E, gets lower.

“Most of the damage in the market this year has not been earnings-related but P-E-related,” notes Jonathan Schoolar, equity director for the $12.5-billion-asset AIM mutual funds in Houston.

The S&P; 500 index P-E was 20 or higher in the early ‘90s, when earnings were depressed. Now the index is priced at 14.8 times analysts’ consensus S&P; earnings estimate for 1994; for 1995, the price is 13.1 times estimated earnings, according to Zacks.

Ultimately, the question becomes: How cheap is too cheap for stocks? That will depend on what happens with interest rates, inflation and earnings over the next few years. The wildly bullish case is that rates stop rising, inflation stays low and earnings keep growing--a combination that almost certainly would set the stage for another explosive market rally.

But many veteran money managers aren’t willing to bet the ranch on that scenario. Instead, they say, the smarter strategy today is to accept that the market is in a very cautious mode--if not in an outright bear phase--and invest with the tide instead of against it.

How to do that? One major change, say some pros, is that the risk in chasing the few remaining “hot” stocks (typically high P-E issues) now far outweighs the potential reward. In a market where P-Es are compressing across the board, the highest P-E stocks are naturally the most vulnerable to any bad news.

Generally, “you don’t want to buy the stocks that are at their highs, because they’re probably the next things to correct,” argues Dan Miller, manager of the Putnam New Opportunities stock mutual fund in Boston.

Case in point: Health maintenance organization Mid Atlantic Medical Services plummeted from $49.50 to a low of $36.875 last week when one analyst suggested that the firm’s quarterly earnings hinted at weaker growth ahead.

At its peak price of $56.625 in June, Mid Atlantic was priced at 39 times its most recent 12 months’ earnings per share. Now, with the stock’s price at $41.375, its P-E is a far less stratospheric 22.

For much of the 1991-93 period, “momentum” investing ruled the day. Money chased the high-flying stocks, and bargain hunting was considered a losing proposition. You stayed with the stocks that were going up--no matter how overpriced they got--and ignored those that went down.

Now, the savvy investor will take the opposite approach, Miller and others contend. Look for companies whose stocks have been slammed, yet whose long-term outlook remains healthy and whose P-Es are reasonable.

“Our strategy is to buy what’s down and where we have the greatest confidence in the outlook,” Miller says.

One example, he says, is LDDS Communications, a fast-growing provider of long-distance phone services. The stock has been cut down with other telecom issues this year. At $19 now, LDDS is off 36% from its peak of $29.50. Its P-E, based on 1994 estimated earnings, has tumbled from 28 to 18.

Of course, nothing says that a stock that’s down 40% can’t fall another 40%. But if you’re investing in high-quality issues for the long haul, your odds of success naturally increase if you buy into declines rather than into manias.

“When you have decent (stock) stories that are down 30% to 40%, somebody’s going to make a lot of money” when the market eventually turns, argues AIM’s Schoolar. “The only way I know to deal with selloffs is to buy them.”

Klassen, whose Vista Growth & Income fund has been nibbling at such beaten-down issues as PepsiCo (at $30.125, it’s down 29% from its 52-week high), notes that bargain hunting in a bear market makes perfect sense. Yet it remains a hard sell for the many portfolio managers who have been momentum players since 1990.

“A lot of people have learned to chase a stock when it’s breaking out” on a chart, Klassen says. Those investors are wholly unprepared to deal with a market where most stocks are breaking down instead of out.

Yet the momentum players’ reluctance to buy bargains means they’re probably leaving plenty of money on the table in those stocks, Klassen says. That’s found money for fundamental investors who can afford to be patient.

Earnings: Still on Track

Whatever ails the stock market, it isn’t corporate earnings: Strong second-quarter profit reports are bolstering analysts’ expectations that earnings will continue to rise into 1995, albeit at a slowing pace. Annual percent change in operating earnings for the Standard & Poor’s index of 500 major corporations:

1995 (estimates): 13.5%

Sources: Lehman Bros.; Zacks Investment Research

Price-to-Earnings Compression

Even though corporate earnings continue to grow at many companies, the prices investors are willing to pay for stocks are coming down relative to earnings per share (EPS). Here’s a look at price-to-earnings ratios (P-Es) at two points for 12 stocks: At the stocks’ peaks over the past year and currently.

52-week Fri. Est. ’94 P-E on ‘ Stock high-low close EPS At peak Brinker Intl. $33 5/8-19 7/8 $23 $0.90 37 Caesars World 59-35 3/4 40 5/8 3.55 17 Chrysler 63 1/2-39 1/2 47 5/8 8.00 8 Colgate-Palmolive 65 3/8-46 3/4 51 7/8 3.85 17 Compaq Computer 39 7/8-14 3/8 30 3/4 3.18 13 Deere & Co. 90 7/8-62 3/4 69 1/8 6.00 15 EMC Corp. 23-11 3/4 14 7/8 0.95 24 LDDS Commun. 29 1/2-14 19 1.05 28 Merrill Lynch 51 1/4-34 1/4 36 3/8 5.85 9 Pepsico Inc. 42 1/2-29 7/8 30 1/8 2.25 19 Thor Industries 30 3/8-16 5/8 22 1.75 17 U.S. Healthcare 47 1/2-26 5/8 37 1/4 2.30 21

94 EPS: Stock Now Brinker Intl. 26 Caesars World 11 Chrysler 6 Colgate-Palmolive 13 Compaq Computer 10 Deere & Co. 12 EMC Corp. 16 LDDS Commun. 18 Merrill Lynch 6 Pepsico Inc. 13 Thor Industries 13 U.S. Healthcare 16

Source: Value Line Investment Survey; Times research