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.
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