October 10, 2011 – By Caroline Valetkevitch
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NEW YORK (Reuters) - The stock market is riding a wave of renewed optimism and investors looking for a reason other than Europe to keep buying may find it in earnings.
The European debt crisis and worries about U.S. growth pressured the market greatly in recent months. Since hitting 13-month lows last week, though, stocks have rallied sharply, putting bullish investors back in the driver's seat as shorts scramble to cover big bets.
This feel good mood may not be over.
The market's lousy psychology for most of the past two months -- built on expectations for poor economic growth and a worsening euro-zone crisis -- could mean investors are still expecting disappointments. Such cautious expectations might end up helping stocks if results are not dismal.
"I think the worst-case scenario has already been built into these stocks because of Europe," said Paul Mendelsohn, chief investment strategist at Windham Financial Services in Charlotte, Vermont.
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Analysts' forecasts for S&P 500 companies' profits have come down slightly in recent weeks. They expect a rise in profits of 12.6 percent compared with the third quarter a year ago. On July 1 their forecast was for 17 percent growth, Thomson Reuters data showed.
Given the big losses stocks have seen recently, gains could actually be in store for the market, some analysts argue. The benchmark Standard & Poor's 500 index is down roughly 10 percent since the beginning of the third quarter.
"We're of the belief that when we get some news out, the market's reaction is probably going to be positive just due to the fact that we've clearly priced in a lot of pessimism," said Thomas Villalta, portfolio manager for Jones Villalta Asset Management in Austin, Texas.
VALUATIONS STILL COMPELLING
Investors have worried that the European debt and U.S. growth problems, as well as possibly less-robust expansion in China, hurt third-quarter results. With recent U.S. economic data coming in better than expected, it has given investors hope that company results will be strong enough to bolster stock prices.
Unlike the euro-zone crisis, a vast problem that causes investors to respond mostly at an emotional level, earnings reports allow for direct comparisons to current market valuations. And by many measures, stocks are relatively cheap.
The price-to-earnings ratio of the S&P, that is, a measure of the price paid for a share relative to the company's profit, is low by historical standards. The S&P 500's forward P/E of 10.8 is at its lowest in roughly 10 years.
"Even if the earnings deteriorate somewhat, you're still in a good area," said Standard & Poor's analyst Howard Silverblatt.
The third quarter is still on track to be the second-highest earnings period, in dollar terms, on record after the second quarter, Silverblatt said.
Thomson Reuters estimates third-quarter earnings will total $230 billion.
Sectors expected to see the biggest growth are energy and materials, with gold repeatedly hitting records in recent months and oil at historically high levels, Thomson Reuters data showed.
"There's a lot of a cushion already built into the average stock to compensate for a variance in earnings plus or minus," said Mendelsohn.
Mike Jackson, founder of Denver-based investment firm T3 Equity Labs, sees a high probability of an earnings upside surprise this reporting period.
In terms of sectors, he puts industrials on top in terms of the potential for an upside earnings surprise, followed by utilities, financials, consumer staples and information technology.
"You've got the true driver of the market (earnings) continuing to go forward and the market going south. That's unusual," he said. "There's a fairly good chance of surprise at the index level and at the sector level."
(Reporting by Caroline Valetkevitch; Editing by Andrew Hay)