Do Earnings And Fundamentals Even Matter Anymore?

by: Wall Street Sector Selector

by John Nyaradi

Last week's earnings reports were dismal, to say the least, and yet markets rallied to new record highs. Analysts who focus on fundamentals like earnings, PE ratios, top and bottom line revenues and other such fundamental indicators must be feeling totally irrelevant as the stock market seemed to shrug off all of these conventional tools in favor of soothing words from Ben Bernanke in his testimony before Congress.

Last week, "Big Ben" assured markets that easy money was going to continue, in spite of rumors to the contrary, and markets liked what they heard. The Chairman repeated that the dreaded taper of the quantitative easing program would be triggered by stronger economic data than what we are currently seeing.

For the week, the Dow Jones Industrial Average (NYSEARA:DIA) and S&P 500 (NYSEARCA:SPY) set new record highs, while the only exception was the tech sector, which tanked as Microsoft (Nasdaq:MSFT) disappointed in its earnings report. The other big news for the week was Detroit's bankruptcy filing, but this didn't seem to bother investors either. They also remained thick-skinned as the tech sector sank on Friday, following a number of earnings disappointments after Thursday's closing bell. Earnings shortfalls by a number of tech giants sent the Nasdaq into the basement on Friday.

Microsoft sank 11.40 percent after reporting quarterly earnings per share of 59 cents on revenue of $19.9 billion, missing estimates of 75 cents per share on revenue of $20.73 billion. Google (NASDAQ:GOOG) fell 1.55 percent after reporting quarterly earnings of $9.56 per share on net revenue of $11.1 billion, falling short of estimates of $10.80 per share on net revenue of $11.4 billion. American Micro Devices (NASDAQ:AMD) took a 13.15 percent nosedive, despite reporting a "less bad than expected" quarterly loss of 9 cents per share on revenue of $1.16 billion, beating estimates of a 12-cent-per-share loss on revenue of $1.11 billion. A downgrade to "underperform" by Credit Suisse was compounded by another downgrade to "underweight" by Morgan Stanley to bring an unexpectedly hard hit to the chip manufacturer.

Stock market levitates to new highs on weak earnings

So does "Big Ben" trump everything? Apparently so, as the S&P 500 repeatedly sets new record highs. What has kept stocks flying? NOT QUARTERLY Earnings as the list below clearly demonstrates:

  • United Parcel Service (NYSE:UPS) – On July 12, the company announced that it was lowering its profit forecast for the year and that it expects to report earnings of $1.13 per share on July 23. Although analysts were expecting annual EPS to reach $4.98, the company lowered its guidance to a range between $4.65 and $4.85.
  • Yahoo (NASDAQ:YHOO) – Although Yahoo's earnings of 35 cents per share beat estimates of 30 cents per share, the company fell short at the top line, reporting quarterly revenue of $1.07 billion, compared with estimates of $1.8 billion.
  • Google – Google reported quarterly earnings of $9.56 per share on net revenue of $11.1 billion, falling short of estimates of $10.80 per share on net revenue of $11.4 billion.
  • Intel (NASDAQ:INTC) – Intel reported quarterly EPS of 39 cents on revenue of $12.8 billion, missing estimates of 40 cents per share on revenue of $12.9 billion.
  • Coca-Cola (NYSE:KO) – Coke reported quarterly EPS of 59 cents on revenue of $12.75 billion, compared with estimates of 63 cents per share on $12.96 billion in revenue.
  • American Micro Devices – AMD reported a "less bad than expected" quarterly loss of 9 cents per share on revenue of $1.16 billion, beating estimates of a 12-cent-per-share loss on revenue of $1.11 billion
  • Microsoft – Microsoft reported quarterly EPS of 59 cents on revenue of $19.9 billion, missing estimates of 75 cents per share on revenue of $20.73 billion.
  • IBM: Big Blue reported quarterly EPS of $3.91 on revenue of $24.9 billion. Although it beat the EPS estimate of $3.77, it missed the revenue estimate of $25.37 billion.
  • FedEx (NYSE:FDX) – FedEx beat quarterly EPS estimates of $1.96, reporting earnings of $2.13 per share. However, its quarterly revenue of $11.45 billion fell short of the estimates.
  • Bank of America (NYSE:BAC) – Bank of America reported quarterly earnings of 32 cents per share on $22.2 billion in revenue, beating EPS estimates of 25 cents by giving pink slips to 7 percent of its employees while falling short of the revenue estimates of $22.79 billion.
  • Citigroup (NYSE:C) – Citi reported EPS of $1.34 on revenue of $20.5 billion, beating estimates of $1.17 per share on $19.79 billion in revenue.

Of course, a common thread in the earnings reports above is that weakness is seen in tech, consumer and transportation, while financials remain relatively strong.

With such a lackluster earnings reporting season under way, two questions come to mind: How is it that the S&P 500 keeps hitting new record-high closing levels and can the S&P 500 continue marching higher if earnings continue to falter?

The simple answer is that investors remain enthusiastic about the fact that no date has yet been scheduled for the reduction in the Federal Reserve's bond-buying agenda within the quantitative easing program. Most people mistakenly interpret the Fed's stated desire to maintain "a high degree of monetary accommodation for a considerable time" to include the asset purchase program. Such is not the case, and Ben Bernanke tried to make that clear during his testimony before the Senate Banking Committee on Thursday.

Are Stocks Cheap?

At the New York Fed's Liberty Street website, FRBNY economists Fernando Duarte and Carlo Rosa tackled the question: Are Stocks Cheap? Their analysis demonstrated that "exceptionally low yields are more than enough to justify a risk premium that is highly elevated by historical standards." The authors defined the term equity risk premium as "the expected future return of stocks minus the risk-free rate over some investment horizon." To oversimplify: The exceptionally low Treasury yields resulting from the quantitative easing program have motivated investors to embrace risk to a degree they would not have in the absence of the Fed's bond-buying.

Another approach to answering the question of whether stocks are cheap is to consider the Earnings per Share (EPS) for the S&P 500 in terms of Robert Shiller's "Cyclically-Adjusted Price/Earnings Ratio" or CAPE, rather than the trailing twelve-month P/E ratio, which is currently 18.22. Using Shiller's formula of averaging earnings over a ten-year time frame, the CAPE (also known as the "P/E 10") is currently 23.5 – a much less-attractive price/earnings ratio, which tells you that stocks are about as expensive as a reasonable investor should be willing to pay.

But why worry about earnings if quantitative easing keeps motivating investors to embrace more risk, driving demand – and hence, stock prices – ever higher, regardless of what ever measure you want to use for a price/earnings ratio?

As economist John Hussman of The Hussman Funds recently pointed out:

It's all well and good to believe that "QE makes stocks go up" and that no other consideration is necessary, as long as one also recognizes that the only way QE has exerted this effect is by encouraging investors to reach for yield and to accept inadequate risk premiums on securities that have always demanded greater risk premiums over time.

So far, the Fed's program has been working as stocks keep marching higher regardless of important fundamentals like earnings from bellwhether companies. Can it continue? We're going to find out. Another important question is what happens when we encounter one of those events, which Dr. Bernanke describes as "unanticipated shocks"?

As Dirty Harry used to say: "Feel lucky, punk?"

Disclosure: Wall Street Sector Selector actively trades a wide range of exchange traded funds and positions can change at any time.