Wednesday, October 17, 2007

Are S&P Earings Real or Imiganed?

Almost one-half of the earnings of the S&P 500 Index come from foreign sales. As the dollar declines, the profits they earn in Euros and other foreign currency translates into higher dollars. So, are these real earnings or just paper profits?

These currency translations remind me of the earnings reported by companies in the 1990’s from the out performance of their pension funds. Companies could report, in their current earnings, the amount of unrealized profits their pension funds made in excess of their target returns.

If a company had a target investment return in their pension fund of eight percent and produced 10% then the company could inflate their current earnings by the two percent above the target rate of return. In today’s market, any earnings that are earned in local currency are counted at the currency exchange rate. If the company for example sells in England, it is paid in pound sterling. When the company calculates the value of their foreign earnings in pounds and converts those earnings to the US Dollar, they get over inflate earnings by the decline in the dollar vs. the local currency they made the sales.

The dollar will not go down forever and at some point in time, the dollar will reverse direction. The disadvantage of foreign earnings will work against the income statements of those companies that are benefiting from a weak dollar.

Why is all of this important?

The forecasters are looking for earnings for the third and fourth quarter to slowdown, but they will still be positive or at least many people hope they will be positive. The fundamental people look at the price to earnings (PE) ratio to evaluate the pricing in the market. If they believe that a fair value for the market is 18 times PE multiple and the current market is 15 then they say we have upside.

However, what if the current 15 times PE are in fact built on the sand of the dollar decline? If you take out some of the advantage of the currency then the real earnings may not be growing at all. If earnings were not really growing, then a normal PR Ratio would have to be less than 18 time earnings.

With all the bad news, the market seems to want to go higher. In my 35 years of investing when I have seen a total disregard for risk watch out because many people will be burned. If you are distracted from the risk, you are taking in stocks because of the concern you have with the value of your first and or second home you are likely to be burned in both investments.

The news in the real estate market continues to get worse and worse. I sill think we are not yet half way through the problem and a great deal more damage will be done to the homeowner. The stock market may begin to realize after earnings season the difference between real and ginned up earnings.


Dan Perkins

1 comment:

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Will Walters