Stock Market Fundamentals -- Earnings

First of a three part post on market fundamentals.

The recovery of profits began when expected, and has been strong
to date, also as expected. The initial surge of the recovery was
heavily influenced by cost cutting and the lower weight given to
failed major companies in the SP 500. Net per share just topped
$57 in '09 and about $10 of that reflects a much lower cost
structure going forward.

The lead indicators for profits suggest a strong recovery trend
well into Q3 '09. There is good potential for further improvement
in profit margins as higher sales and operating rates generate
efficiencies via rising productivity and even betters spreads over
fixed costs.

Analysts are raising earnings estimates as the ecoonomy progresses.
This is a normal development. So far, estimates for 2010 have been
increased by $3 per share or 4% for the SP 500.

The $ cost of production, a decent proxy for business sales, is in
an upswing and was up 3.8% yr/yr through Feb. Measured yr/yr,
profit margins tend to expand cyclically when the $ cost of output
exceeds 5%. The volume of recovery in goods and services this year
should exceed 5% over 2009, even without taking pricing into
account. Right now, pricing power remains narrow and limited
overall.

Analysts project SP500 net per share to top $78 this year, but that
number could well be bumped up to $80 over the next month or
two. The $80 figure compares to the revised record for 12 month
eps of $91.47 set in mid-2007. Sp 500 net per share on a 12 mo.
basis first topped $80 back in 2005.

At this stage, one should take 2011 earnings estimates as they come
out with double the normal grains of salt. This is because the US
and other major economies have been supported by the largest
fiscal and monetary stimulus programs ever, and because the
authorities will feel increasing pressure to exit these programs as
recovery progresses. Numerous program exits starting in late
2010 and running through 2011 will prove a drag on global growth
even if economic recovery is fully self sustaining.

Corporate earnings growth has accelerated over the past 20 years.
Companies manage balance sheets far more aggressively than
ever before. Strong pressures to boost performance have led to
higher profit margins and return on equity %, but have led to
ever greater volatility of cyclical performance as companies shed
losers and mistakes during downturns. As a consequence, ROE % is
up, but growth of book value has been stunted. Moreover, faster
growth is less appealing when growth visibility is reduced.