As we enter the heart of fourth quarter earnings season, coupled with a growing consensus in the marketplace that 2011 may finally be a better year for stocks, many advisors should expect a discussion about equities to take the forefront in client conversations.  To keep their clients focused, advisors need to guide them to look at two variables when allocating to the equity markets:  the earnings they expect to receive over the coming year, and the multiple the market is willing to pay for each dollar of those expected earnings.  Consensus estimates from analysts across Wall Street project the S&P 500 to generate approximately $96 in operating earnings for 2011, and $105 in 2012, both of which our J.P. Morgan Funds strategists believe are achievable.  Moving forward, while we expect the rate of quarter-over-quarter earnings growth to decelerate to the low single digits from the double digit growth we saw in 2009 and early 2010, we do believe that margins, and ultimately earnings, will continue to rise.

To create a framework for conversations advisors should be having with their clients about how to interpret Q4 2010 earnings, it is helpful to take a moment to put history in context.  Back in Q207, S&P 500 operating earnings peaked at an all-time high of $24.06.  Then came the worst earnings recession in recent history, which ultimately drove Q408 operating earnings down to $-0.09.  Since then, companies have aggressively cut their costs in an effort to improve their margins, and as a result, this operational leverage has helped generate a v-shaped recovery in corporate profits, with Q310 earnings coming in at $21.58, only 10% below their 2007 peak.  Our belief that operating earnings will exceed the old peak of $24.06 over the next year is driven by two factors: first, that margins have some room for additional growth – driving up Net Income, and second, that share buybacks will pick up in 2011 reducing shares outstanding – lifting EPS through the use of financial leverage. 

For advisors striving to make the case to their clients about the opportunities in equities as an asset class, we would argue that S&P 500 profit margins will likely continue to rise, exceeding their all-time high over the next two years.  When we look at a company’s cost structure, we often find that labor is its largest expense, and with 15 million unemployed Americans today, companies have the upper hand at the negotiating table.  It appears it will take another four to six years before the economy reaches full employment again, and as a result, we believe that wages will remain depressed in the near term, even as companies begin to accelerate their hiring.  Additionally, low depreciation and interest expense due to a cut-back in capital expenditures, coupled with low interest rates, should also create a tailwind for growth in margins.  As we continue to see top-line revenue growth from a strengthening global economy, each dollar of incremental sales will have a much bigger impact on the bottom line, driving profits higher over the coming year.

Another point that may be compelling for advisors to incorporate in their client discussions is the outlook for share buybacks and their potential to fuel growth in 2011.  With companies in the S&P 500 sitting on record amounts of cash, the question we’re often asked is:  how will they spend it?  While there are a variety of uses for cash, we expect that share buybacks will pickup considerably over the next year.  Rather than pay a special dividend to distribute a company’s excess cash, share buybacks are unique as they have an accretive effect beyond the initial transaction.  Without increasing the dividend payout ratio, when a company does a share buyback, its future dividends and earnings per share will likely increase as there are less shares outstanding (a lower denominator in both DPS and EPS).

As earnings continue to rise, the next step for advisors is to help their clients to think about where multiples may be heading, which admittedly is a bit trickier.  Based on the S&P 500’s closing price at the end of 2010, investors are paying 13.1x forward earnings.  Considering a historic average of 16.5x forward earnings, stocks appear relatively cheap.  Through our research, we’ve indentified a strong relationship between forward multiples and consumer confidence, with a correlation coefficient of 0.72.  Although it is almost certain that a few unforeseen headlines will rattle investor confidence over the coming years and create unwanted volatility (as they always do), from a fundamental standpoint, our outlook for long-term investors in the equity markets is still positive.  As the economy gains momentum and the labor market improves, we believe that sentiment will rise, driving modest multiple expansion in 2011, and lifting equity prices higher.  If 2012 earnings estimates remain unchanged at approximately $105, even a small expansion in multiples could create some decent returns for investors over the coming year.  It is critical for advisors to engage in balanced conversations with clients about the prospects for equities, given the understandable hesitancy about this asset class in the wake of the financial crisis.  Clients maintaining an unproven prejudice against equities in their portfolios risk missing out on a potentially significant source of returns in 2011 and beyond.

Mr. Tanious is vice president and U.S. market strategist at J.P. Morgan Funds.