Can Earnings Gains Satisfy the Lofty Hopes of Analysts on Wall Street?

For two years U.S. companies have been absolutely masterful at squeezing blood from a stone--spectacular earnings from a generally sub-par global economic expansion.

But how much blood is left to be wrung to the bottom line? Plenty, if you believe Wall Street analysts’ collective view. They see a lot of good earnings news still to come, well into 1996.

And with share prices at record highs, the stock market clearly is buying into that optimism. Indeed, there’s a strong argument that the only thing keeping the bull market going today is the belief that stocks still are reasonably priced relative to expected earnings.

The key word there is “expected.” If you look solely at what Corporate America has already produced in terms of earnings, and relate that to current stock prices, history suggests that we’ve reached the upper limit of fair valuation for the market.

Consider: Taken as a group, the blue-chip Standard & Poor’s 500 companies have earned $34.62 a share over the past four quarters. With the S&P; index at a record 572.68 as of Friday, divide the earnings figure into the index and you get a “price to earnings” ratio, or P-E, of 16.5 for the average S&P; stock.

Investors can debate whether that’s a high or low price to pay for top-quality stocks, but from a historical perspective a P-E of 16.5 “is a little above the average P-E at bull market peaks in the post-war period,” says Arnold Kaufman, editor of S&P;’s Outlook market newsletter in New York.

In other words, it wouldn’t be surprising for the market’s tremendous run to end right about here--anticipating that this is as good as it’s going to get in this business cycle for the earnings that underpin stocks.

But most Wall Street analysts don’t believe that the earnings locomotive is grinding to a halt. At worse, they see earnings gains slowing next year but still maintaining an impressive pace.

I/B/E/S Inc. in New York, which tracks individual company earnings estimates prepared by hundreds of brokerage analysts nationwide, calculates that the sum total of those estimates works out to earnings of $37.86 a share for the S&P; 500 index this year, a 20% gain over 1994 results.

For 1996, the analysts’ individual company estimates produce an S&P; earnings figure of $43.49 a share, a 15% rise over the 1995 estimate, I/B/E/S says.

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If that $43.49-a-share figure is in the ballpark, the average S&P; stock is priced at 13 times estimated 1996 earnings. That’s about where the market was valued last December--before this year’s explosive rally began, pushing the S&P; index up 25% so far.

No wonder the bulls are still enthused about stocks: They assume they’re looking at a replay of 1995 in 1996.

William Dodge, investment strategist at Dean Witter Reynolds in New York, is less optimistic about 1996 results than the mass of analysts. He estimates that S&P; 500 earnings will reach $39 a share.

Yet even with that less-robust figure, stocks overall can rise another 9%--putting the S&P; 500 index at 625--if investors decide to maintain the market’s price-to-earnings ratio at 16, Dodge says. And he believes that in the current environment, with interest rates and inflation subdued, 16 represents a “fair” P-E for stocks.

Research by brokerage Goldman, Sachs & Co. supports that notion. Since 1950, Goldman says, the S&P; 500 P-E has averaged 16.4 in years when inflation was less than 3.5%, as is the case today.

As inflation rises, usually pushing interest rates higher as well, stock P-Es naturally decline as investors’ enthusiasm for stocks wanes. That’s because stocks face greater competition from bonds and other interest-paying securities, and because corporate earnings are judged to be worth less, relatively speaking, if they’re being quickly devalued by higher inflation.

But low inflation, even if maintained, is just one of many elements that will determine stocks’ ongoing appeal. What probably troubles more investors about 1996 isn’t the inflation outlook but rather the potential for analysts to be dead wrong with their corporate earnings estimates.

Foretelling earnings is as much art as science, after all. For analysts to guess what a company might earn in a given period, they must factor in the economic picture (basic demand for the company’s products), the competitive environment and potential changes in the company’s cost structure (e.g., savings from restructuring), among other things.

Thus, at each level an earnings estimate is an “if, then” proposition: “If the economy does this, then Company X might earn this much.”

Put another way, earnings estimates are “predictions based on predictions,” says Richard McCabe, market analyst at Merrill Lynch Co. in New York. Not surprisingly, then, estimates often turn out to be way off base.

Indeed, many analysts got earnings wrong in 1994 and in the first half of this year. However, they were wrong not because they overestimated results but because they underestimated.

The great surprise of the past 18 months has been that corporate earnings have risen much more dramatically than the majority of analysts had expected, I/B/E/S has noted. Analysts have repeatedly scrambled to raise their estimates, only to see many companies beat them quarter after quarter.

Even in the second quarter of this year--as the economy slowed sharply--52% of companies exceeded analysts’ consensus earnings estimates for the quarter, I/B/E/S says. Another 14% reported earnings as expected, while 34% had disappointing results.

Although technology companies’ stellar earnings this year have been well-documented, the mix of industries beating estimates in the second quarter was quite diverse, I/B/E/S says. Airlines, forest products, tobacco and steel were among the industries posting better-than-expected profits.

Evidently tired of consistently being behind the curve, some analysts have been boosting their 1995 and 1996 earnings estimates in recent weeks, despite the economy’s sluggish pace and the threat that the rising dollar poses to multinational firms’ earnings.

Richard Pucci, analyst at I/B/E/S, says his firm in August recorded 1.23 upward revisions in 1995 S&P; 500 company earnings estimates for every one downward revision. The ratio of upward to downward revisions for 1996 earnings was 1.29 to one.

Normally in August downward revisions by analysts outnumber upward revisions by a ratio of 1.25 to one, I/B/E/S says.

For Wall Street’s beleaguered bears, analysts’ sudden willingness to embrace the idea of a continued powerful advance in earnings is more evidence that it’s very late in the bull market party.

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James Stack, editor of the InvesTech market newsletter in Whitefish, Mont., argues that analysts’ capitulation is a classic contrarian “sell” signal.

“When investor expectations for earnings are low . . . they have no place to go but up,” Stack says. “And when corporate profits have been rising for an extended period of time and expectations are for a lot more of the same, that’s when the market is most vulnerable.”

He has a point. And certainly, record low dividend yields and other bearish signals give reason for concern. Yet for most investors the bottom line is the bottom line: It’s the earnings outlook that motivates stock buyers.

Can U.S. companies produce the kind of earnings gains that Wall Street now expects in 1996? Perhaps--if the world economy picks up a bit, but not enough to boost interest rates; if the dollar doesn’t rocket, and if corporate cost-cutting efforts can somehow milk more productivity gains out of workers and equipment.

Those are a lot of “ifs,” but they don’t represent outlandish expectations. And with the S&P; 500 now valued at about 13 times estimated 1996 earnings--a comfortably moderate P-E, historically--”if the earnings estimates for 1996 are even close, the [market] should do well,” argues Jonathan Schoolar, a money manager at AIM Capital Management in Houston.

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Low Inflation, High P-Es

Stocks tend to sell for much higher prices relative to earnings per share when inflation is low, as it is today. Here are average price-to-earnings ratios that have prevailed since 1950 for the Standard & Poor’s 500 stock index, as inflation has varied.

Annualized inflation / Average S&P; 500 P-E

Less than 3.5%: 16.4

Less than 4.5%: 15.4

4.5% to 5.5%: 15.6

5.5% to 6.5%: 12.1

6.5% to 7.5%: 10.0

More than 7.5%: 8.6

P-Es based on trailing 12 months’ earnings.

Source: Goldman Sachs & Co.