Earnings & Elections

After a dismal performance during the first part of the month, stocks tried to regain their footing last week and delivered a gain.  Despite the final effort, which was not all that convincing, it did not prevent October of 2008 from delivering one of the worst monthly performances for the S&P 500, down nearly 17%.

By the close of the month approximately 65% of the S&P 500 companies reported 3rd quarter earnings and appear to be sending profits to an 11.7% decline.  The net result has created a lower P/E ratio for the S&P 500 as a function of stock prices declining more than earnings.

P/E ratios may be in even better shape due to the effect of those companies reporting losses.  As an example, a healthy company with a market value of $100 billion and earnings of $5 billion has a P/E of 20.  Combined with an unhealthy company with a market cap of $5 billion and losses of $4 billion creates a market value of $105 billion, earnings of $1 billion, and a P/E of 105.  This obviously does not make sense and is one of the pitfalls of looking at combined P/E ratios at a time when some companies are experiencing massive losses.  While the S&P 500 P/E ratio has come down recently it is still well above the level that has historically been associated with new bull markets.

The stock market has historically led economic recoveries and the resilience of the U.S. economy has consistently demonstrated outstanding recovery capability in the last few recessions.  It is still unclear, however, if we have complete visibility regarding the problems that remain in the off-balance sheet activities of commercial banks.  In addition, consumer spending contraction appears to be in the early stages and if a more saving conscious (or debt reducing) consumer is part of the overall solution, the business sector is going to feel the pinch.  Add to the mix state and local governments in financial trouble with more than 30 states faced with large deficits, and this recovery may take longer than expected.

Elections are tomorrow and the outcome may result in an increase in dividend and long-term gain tax treatment.  The uncertainty around future tax rates has created an additional consideration in an already challenging investment environment.  If the possibility of higher taxes does materialize, it may influence a change in the structure of our taxable portfolios.  Regardless of who prevails in the Presidential and Congressional races, it is my hope that tax rates are not raised and our elected government representatives focus on spending cuts to balance the budget and reduce the deficit.

With P/E ratios a little higher than we would like, several economic headwinds still blowing strong, and a potential change in tax policy, we are maintaining our defensive bias.