This year has brought a number of troublesome developments, such as the turmoil in Libya, the earthquake in Japan, the weak U.S. dollar, and a ratings agency this week expressing concern over U.S. debt. Despite all this apparently bad news, the stock market has managed to work its way higher. Some people may wonder if the market is starting to show excessive optimism again. The answer is no, largely because of corporate earnings strength.
Profits are the primary determinant on how well business is doing. This is true whether in the case of a sole proprietorship or large corporation. Outside events such as wars ultimately only matter to the stock market to the extent that they impact profits. The events throughout the world certainly may impact corporate profits at some point, but through the first quarter of 2011, the impact has been minimal.
The early reports for first-quarter earnings have largely been positive. There have been strong results in technology companies, such as Intel and Apple, and impressive results among industrial firms like Honeywell and United Technologies. American companies continue to benefit from strong growth overseas. The only area which has not seen as much strength is among the banks, due to weak real-estate lending.
If the results for the first quarter are maintained throughout the year, 2011 should be a record year for corporate earnings. The effects of the earthquake in Japan will certainly impact some industries due to supply disruptions over the next several quarters. The impact will be that the rate of change of earnings growth will slow, but it should remain positive.
Despite earnings likely to reach record levels in 2011, the stock market is still about 15% below its peak level reached in 2007, as measured by the S&P 500, an index of 500 large companies. This basically implies that there is not excessive optimism, but rather uncertainty about the future course of the economy. Profit margins are currently at relatively high levels, so future gains in earnings will need to come from revenue growth.
Going forward, earnings will likely slow. As of now, it does not appear that any of the potential problems lurking are serious enough to cause earnings to contract. Given this outlook, it is appropriate to maintain normal positions in the stock market, as equities are still reasonably valued, especially given how low interest rates currently are.
