Stocks Hold Appeal Despite Slowing Profit Growth

But regardless of whether earnings per share for the companies that make up the S&P 500 index were 10% higher in the fourth quarter than a year earlier — or 10.1% as Reuters Estimates puts the number, or 9.8% as Standard & Poor's projects — the extent and duration of the corporate-profits boom has been no less than remarkable. In fact, the present level of earnings is 30% above the historical trend line, says Binky Chadha, chief U.S. equities strategist at Deutsche Bank in New York. Do 57 months of double-digit earnings growth constitute a miracle?

Hardly, Chadha says. He forecasts 9% earnings growth this year for the S&P, which would, indeed, indicate a slowdown. But the real question investors should ask themselves is why hasn't it slowed even more, he says.

The resilience of earnings reflects more a coincidence in timing of factors than anything else, according to Chadha. Profits have been growing at such high rates, in part, because they're coming off low levels. The combination of a cheap U.S. dollar, high energy prices and a slowdown in wage inflation explains much of the stellar earnings growth of the past few years, he says.

And if, indeed, corporate growth is running out of steam, it would make sense to fear — as some on Wall Street do — that stocks will start to look more expensive relative to earnings. But far from being pricey, Chadha maintains stocks are 8% to 10% cheaper than fair value. "Equities are cheap," he says. "It's important to keep in mind, that up until last summer, the rise in equity prices was well below increases in earnings we were seeing."

SmartMoney.com: Will fourth-quarter results extend the current earnings growth streak?

Binky Chadha: By my counting, it's the 19th consecutive quarter of double-digit growth. So yes, absolutely it's a new record. The important thing to keep in mind is the pattern of earnings growth since 2002, when the economy began to recover, which is typical of economic recoveries, is that earnings grow at high rates because they're coming off of low levels. And earnings growth did begin to slow, and it has come down a lot. So it's important to keep that in mind. The question is really, why hasn't it come down more? We should be a lot closer to trend levels of growth, closer to 6%.

SM: Are there any distorting factors that might account for the long period of double-digit growth?

BC: In my view there are three things that have prolonged the period of high above-trend earnings. One is the cheaper dollar, which is important for S&P 500 earnings. The second reason is higher energy prices. It might sound counterintuitive. But energy is 10% of the market cap of the S&P 500 index. When energy prices go up, the market goes up, so it's contributing a lot to aggregate earnings. And third, wage inflation has been slow to pick up than in the past. I believe the reason for why is simply the fact that we're at a point in time when aggregate unemployment is 5%.

But all the sectors in the U.S. economy are not tight. We have autos in long-term decline, and concerns in the housing sector. In some sectors we have slack, and there's likely to be more slack. Everywhere else things are tight. If things were tight everywhere I think we'd have wage inflation kick in. Now we have more sector dispersion. Some of them have slack, some don't. That difference in where we are across sectors is keeping, I think, the slowing wage inflation we're seeing.

Weakness in autos and manufacturing is actually good for the market, because it's slowing wage inflation. I don't think it's any miracle, or some new structural force that some people argue as to why wage inflation is low. I think it's more to do with the cycle, and more to do with the lower dollar and lower energy prices.

I expect earnings growth to continue to slow. I think it's going to happen more slowly than others. We think the dollar has further to fall and that should provide support to U.S. corporate earnings; 25% of S&P 500 earnings come from abroad.

SM: Will stocks start to look more expensive then?

BC: No, I'd argue the opposite. Stocks are cheap. The first fact to keep in mind is that equity markets have been recovering since 2002-03. But over the last five years or so, equity price appreciation has not kept pace with the stellar earnings growth. Equity prices are growing at lower rates than earnings growth. That means equity price valuations have been falling since late 2001 through the summer of last year. So that's four and a half to five years of declining equity price valuations. The P/E ratio of the S&P fell consistently from 2001 to 2006; that's the longest fall of equity price valuations since World War II, since these things were recorded. So equities have been getting cheaper and cheaper because equity price valuations had run up very high during the bubble years.

In terms of fundamental valuation on the S&P 500 index, we look at two key drivers: interest rates and long earnings expectations. They tell us that the declining valuation process should be over. And it means that going forward equity price appreciations [and earnings growth] should be more closely aligned. For this year I expect earnings growth of 9% for the S&P 500; and a 9% increase on the S&P 500.

SM: How much more room do stocks have to grow?

BC: One way to answer that is to think about fair value for U.S. equities. Right now U.S. equities look 8% to 10% cheaper to fair value. If nothing happens, if earnings are flat, and risk premium against equities goes away, equities have 8% to 10% more to grow (for this calendar year). [That's] because they're cheap.... And that's in very sharp contrast to almost all other asset class. Government bonds look expensive. Credit spreads are near 20-year lows. But equities are cheap. It's important to keep in mind, that up until last summer, the rise in equity prices was well below increases in earnings we were seeing. So that means valuations were falling. Equities were getting cheaper and cheaper.