The End of Earning Downgrades?

by: FP Trading Desk

The severe earnings downgrade process peaked in January of this year as more than 80% of changes to 12-month forward estimates were down. The sharp downgrades to 2009 estimates continued throughout the first half of 2009 and resulted in expectations for a 25% earnings decline this year. This followed an 8% drop in 2008.

But earnings momentum has finally started to turn, with estimate downgrades getting less frequent. This change seems to have played some role in the rally in equities seen since March 9, according to Jeffrey Palma, global strategist at UBS.

“With earnings in decline, the rally in equities was afforded by multiple expansion,” he told clients, noting that global equity valuations expanded from a trailing P/E ratio of under 10x to 16x. On a price to book value basis, valuations moved from 1.2x to 1.6x.

So while these multiples are still below their long-term average and may have room to expand further, the power of the valuation case to drive equity returns from here has been reduced, according to Mr. Palma.

As a result, the ability for equities to move higher is therefore increasingly dependent on the outlook for earnings. This year may look clear enough, but investors will likely turn their attention to 2010 in the coming months.

With numbers suggesting a strong earnings recovery in the order of 22% (ex financials) next year, Mr. Palma points out that much of the rebound will be driven by base effects, such as large earnings rebounds from depressed earnings in Japan.

As the market waits for more clarity on the earnings recovery next year, UBS expects equities to remain range bound. Mr. Palma also thinks the popularity of rotation strategies out of high beta stocks and sectors into high quality names, which have lagged in the recent rally but offer stable earnings growth and attractive valuations, is set to continue.