US profits picture is distorted

Investors seem to be seeing nothing but good news in the US stock market. The S&P is back on a four-year high and the Dow Jones is near the psychologically important 11,000 level.

Investors seem to be seeing nothing but good news in the US stock market. The S&P is back on a four-year high and the Dow Jones is near the psychologically important 11,000 level.

This makes sense, says Brian Stine of Allegiant Asset Management on Bloomberg.com. Oil prices are down, so worries about inflation and its attendant rate rises have been calmed: the market now thinks the Fed may indicate its latest tightening cycle is over as early as next week.

At the same time, "the economic figures look good". Industrial production rose 0.9% in May, its best showing since mid 2004, suggesting profit numbers could surprise on the upside next year. To many, the market also looks cheap on a p/e of 16.5 times. "Wall Street has underperformed world equity markets for nearly four years. Next year could be the year it makes up for some of that lost time," says Mike Lenhoff in The Business.

But not everyone is convinced. To some, next year could instead be the year that the US stockmarket finally succumbs to the bear. For starters, says Philip Coggan in the FT, US stocks aren't as cheap as the bulls think. The current measure by which companies report their profits flatters the real picture: the earnings number used in the calculation tends to be operating earnings per share, a number that ignores some of the charges and also allows companies to count as profits the "assumed" rate of return on their pension-fund assets, regardless of whether a positive return has been achieved or not. If you exclude these distortions, you get a very different picture. For the financial year 2005, operating earnings for companies in the S&P 500 index are expected to be $77.02 per share, but the core measure would actually be $64.87. This would give the S&P 500 index an average p/e of 19.5 times, a number you couldn't even begin to claim as cheap.

It is also far from a given that the US economy is out of the woods. Inflation is still a problem (the oil-price fall may well be temporary) and that means that rates may still rise further. That in turn could spell trouble for America's precarious housing market: Capital Economics predicts that even a soft landing here could be enough to tip the consumer-dependent economy into recession next year.

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