In fact, earnings are acting in much this way because the growth in the aggregates is being driven by cyclical industries such as energy, metals and mining, and until recently, housing. Unlike the 1990s, when profit gains were led by growth engines such as tech, pharmaceuticals, and financials, these standbys have not been much in evidence recently. (See e.g., Cramer’s Take: Tech’s Four Horsemen Ride in Circles.) While overall recent gains so far have not been “mediocre” (as Doug Kass warned last year that they would be), they have been “lumpy.” The moral of the story is that the composition of growth is as important as growth itself in determining valuations, and ultimately stock price movements. A simple numerical example will illustrate why.  

Suppose in period 1 (e.g., 2005) that cyclical companies initially represent 10% of earnings, and their stocks command an average P/E ratio of 8, while the rest of the market represents 90% of earnings and commands a P/E ratio of 16. Multiplying the respective P/E’s by the respective weights and adding, one comes up with a market cap and “blended” P/E ratio of 15.2. Now suppose in period 2 (e.g. 2006), the earnings of the cyclical stocks (e.g. Alcoa) double, so they represent 20% of period 1 earnings. At the same time, earnings for the rest of the market fall from 90% to 85% of period 1 earnings. Adding the two components, period 2 earnings are now 5% higher than period 1 earnings (85%+20%=105%). But the market cap is just the same as before (.85*16)+(.2*8)=15.2. And the blended P/E multiple has actually fallen, because the same market cap is now divided by earnings of 1.05 rather than 1.00. This example, in fact, appears to be describing the current market action, and is reminiscent of the 1970s. 

One sign of an approaching peak is the steady drumbeat of rate increases from the Fed. This is a signal that inflationary pressures are becoming worrisome, meaning that gains going forward are likely to be nominal (before inflation), rather than real (after inflation)—classic peak behavior. But the rate rises themselves could cause expectations of a peak to become a self-fulfilling prophecy. Almost by definition, they tend to slow economic activity with a 12 to 18 month time lag, meaning that it’s earnings of 2007, not those of 2006, that are likely to take the hit. This accounts for (recently) rising volatility, and a growing level of skittishness.  

For instance, Alcoa sells off, after meeting earnings expectations of a doubling off the old “plateau, because second quarter sales were a tad “light.” (I think they may actually “beat” going forward because many recent price increases took place only 30 days after they were announced, and because the company is experiencing excess demand that it can fill later as new capacity comes onstream). Other reporting companies stand to disappoint, not because results will be objectively bad, but because they won’t be seen as rising above the current “fray” of rising interest rates, high commodity prices, and a growing terrorist/nuclear threat worldwide. The mood may best be described as “Is this all there is?” which is to say that it will be a downer. 

Yesterday, they say, is history and “tomorrow is a mystery,” but “tomorrow” (or the expectation thereof) is what drives stock prices. If as I believe, cyclical company earnings, and hence the aggregates are peaking, they have nowhere to go but down off this year’s high base going into next year. (The recent interest rate hikes will probably hold down compensating gains in other sectors well into 2007.) This was a scenario I had warned about in my April 12^th piece that tried to reconcile weak stock price action with strong current earnings. Under the circumstances, the market is likely to be seen as expensive on next year’s earnings, which is to say I believe that there will be a further correction in the next six to twelve months. Individual stocks recommended by other Street Insight contributors on company-specific merits will buck this trend, and there is always room for another debate as to how long and how severe the correction will be. Still, a cautious posture is recommended at this time. 

© 2006 Thomas P. Au
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Thomas P. Au
R. W. Wentworth
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