The stock market has fully recovered its lost ground from this year’s sell-off. Analysts and investors have now incorporated lower economic growth forecasts, information from company earnings reports/outlooks, and mega-trend fears. Evaluating the earnings adjustments and the stock market’s valuation show a stock market that has recovered from its oversold position. Moreover, future growth remains attractive and the market’s valuation offers the potential for future improvement.
How earnings estimates have changed this year
Interestingly, today’s estimated earnings for the Dow Jones Industrial Average are up this year. However, two offsetting adjustments were made. First, estimates were raised as economic growth forecasts increased. (Remember the economist competition with each forecast leapfrogging the other, until 4+% growth rates were achieved?) Then came the recent earnings reductions as the economic growth rate projections dropped back.
The following graph shows the pattern of adjustments, affecting especially the 2012 earnings estimates.
(Click charts to expand)
The stock market clearly reacted dramatically, caused by the sizeable worry (fear) of mega-trend reversals, particularly a financial meltdown and/or a double-dip global recession. Like last year’s battle with similar fears, the stock market rebounded as the worries dissipated.
Valuations – surprisingly stable, except for market sell-off period
Highlighting investors’ use of estimated earnings for stock valuation (the basic approach to stock investing), the stock market has tracked analyst estimates up and down. The major divergence occurred during the mega-trend fear period.
Return/risk – upside potential has a kicker
With forecasts of 10% earnings growth founded on continuing (albeit slower) economic growth, stock investors should receive a desirable return. However, there is another source of return that could enhance results: investor interest. Many individual and institutional investors and advisers have continued to concentrate on stock market risk. This focus has produced skewed portfolios that are underweighted in stocks, particularly of U.S. companies. The dramatic 2008-2009 drop and the 2010 and 2011 mega-fear sell-offs have kept this risk avoidance alive. However, such an approach is neither normal nor good investing, so will reverse sometime in the future.
The graph below shows the potential return that could be earned by having investors resume a “normal” investing approach to stocks. (Note that “normal” does not mean enthusiasm or widespread optimism.)
The bottom line
The stock market has recovered its recent sell-off and is once again selling at a reasonable valuation level. Earnings, although trimmed, still show decent growth, making stocks a good investment. A bonus return is possible when investor interest in stocks returns to normal.
Disclosure: Long U.S. stocks and U.S. stock funds
