NEW YORK (CNN/Money) - When it comes to earnings estimates, as you've doubtless noted by now, companies are knocking the cover off the ball.
Analysts spent much of last year forecasting that fourth-quarter S&P 500 earnings would gain 22 percent on the year-earlier period. But profits growth is going to be far stronger than that. At least 26 percent. Probably better.
Good news for the bulls and it gets better. Forecasts for earnings growth over the next couple of quarters look light -- analysts and companies alike, scolded for being too bullish in the past, have taken to lowballing the Street. This should make for plenty of positive surprises. Everybody likes such surprises.
End product: Earnings could grow by a good deal more than the currently forecast 13.5 percent in 2004. And the S&P 500's forward (that is, based on forecast results over the next year) price-to-earnings ratio of around 18.5 may be signaling a level of overvaluation that isn't there.
Yet there are those who think that now is not such a swell time to back up the truck.
In a recent quarterly letter to clients, Cliff Asness, managing principal at the hedge fund AQR Capital Management first points out that since 1976 the S&P 500's median forward price-to-earnings ratio has been 12.1. To achieve that, the index's current level earnings would have to grow by around 70 percent over the next year. Somehow this seems doubtful.
Asness prefers not to look at forward estimated earnings, since they're simply guesses and, worse, guesses that can't include any of the inevitable charges that companies incur due to restructuring and the like. By the same token, he doesn't like the "pro forma" results that earnings tracker First Call publishes and instead looks at earnings under generally accepted accounting principles, or GAAP.
Looked at that way, the S&P closed out 2003 with a P/E of 27.9 -- way north of its average of 16 since 1976. Smooth GAAP earnings over 10 years to take out their inherent volatility and the P/E comes in at 27.2 versus 16.9.
Other observers have used different methods of smoothing earnings . Doug Cliggott, who heads up U.S. research for the hedge fund Brummer & Partners, has figured that a quick and dirty method of determining what core earnings are is just to chop 15 percent off the First Call numbers. This tends to yield the same P/Es as Asness'. Brett Gallagher, head of U.S. equities at Julius Baer, uses the government's profit data to figure out where things stand. Again, his read on valuations is very close to what Asness gets.
But do valuations matter?
Yes, it's a question that smacks of the new-economy drivel we heard in the late 1990s. And it may get a new-economy answer: No, not really.
At least not really now. For now, we are in a world where profits are continuing to accelerate, and where reality is trumping even the most bullish forecasts. That makes a lot of investors buyers, regardless of where valuations stand.
But someday economic growth will slow to a steady hum from the current howl and profits growth won't be blowing past expectations the way it is now. Someday, things might even be worse than people expect them to be. And then the market's historically high valuation may matter very much.
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