This week marks the start to earnings season. Much will be made of the possibility for yet another quarter of double digit gains in profits for the second quarter. Still, I would not expect a meaningful market rally as these reports come in, even if we do end the quarter with 11 or 12 percent growth, which I think is likely. The bulls screaming that the market is cheap at 14 times forward earnings are overly optimistic, in my view.
First of all, you can only get a P/E of 13 or 14 if you use operating earnings, which is basically the number companies report after stripping out many various items that negatively impact earnings. If you use GAAP numbers, the S&P 500 is trading at 16 times this year’s estimates, and 15 times 2007 projections. That makes the market fairly valued, based on historical context, not cheap. With double digit profit growth in 2007 unlikely, you can see why I don’t think this market will soar to new highs anytime soon.
Okay, so how do investors play this market? I would focus on stocks that have below-average valuations and with whom you have a high level of confidence that they will at least hit, if not beat, their numbers. Such a strategy gives you the potential for either multiple expansion (which the S&P 500 will not provide) or earnings per share revisions to the upside (which can lead to share price gains even if multiples stay where they are). Obviously, the double play would be to get both.
Finding names that fit this description is not an easy task, but it’s really the only way to make good money in this range-bound market environment.