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Stocks Cheap? Not If You Look at Earnings So Far

Earnings season so far may look respectable, but a disturbing trend lurks below the surface: Companies for the most part are barely beating analyst expectations that already had been lowered substantially.

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That's important as bullish fund managers try to sell their clients — most of whom remain on the sidelines — the stocks-are-cheap theme, bolstered by a historically below-par price-to-earnings ratio for the Standard & Poor's 500 .

Should earningsremain medicore while the European debt crisisintensifies and the U.S economic recovery wobbles, that threatens the early-year stock rally, in which the S&P 500 has gained a healthy 4.5 percent.

"Overall you're still seeing a fairly solid earnings season," says Quincy Krosby, chief market strategist at Prudential Annuities in Newark, N.J. "It's clear, however, that there are headwinds building globally. But the question is, how strong are those headwinds going to be? That's going to keep investors watching reports coming from all over the world, especially Europe."

So far, about one-fifth of the S&P 500 has reported earnings, with 58 percent beating expectations, 30 percent missing and 12 percent matching, according to Thomson Reuters data. The numbers were even thinner for banks, with just 48 percent beating estimates.

Should the remaining 400 companies in the index meet estimates, that would equate to a 5.9 percent profit gain from the same period in 2010.

But the bar had been lowered in a big way heading into earnings.

Analysts who once expected profit growth of 14.6 percent had cut their estimates all the way down to 6.8 percent by the time Alcoa , the traditional kick-off company for the quarterly profit reports, released its numbers on Jan. 9.

Just 54 percent of companies have beaten on revenue, while 46 percent missed. The average earnings growth is 1 percent above forcasts, according to Thomson Reuters.

So with a shaky earnings season well in gear — Apple's blowout numbers Tuesday a notable exception — those counting on a solid "E" for the P/E ratio might want to rethink the theory that stocks are priced at a discount.

"They can get cheaper," Krosby says. "That's the reason that you're seeing investors stay on the sidelines. They know that economists don't have a particularly strong track record as far as predicting the deterioration in economic growth."

Indeed, stock market participation has been anemic, even amid a strong start to the year.

Volume on the New York Stock Exchange in 2012 has run lower than even during the lightly traded holiday season. For the most part — last week being an exception — money has continued to funnel into low-interest bonds and zero-interest money market accounts.

Market sentiment surveys, meanwhile, are at highly bullish — some even say peaking — levels while volatility is greatly subdued. Yet actual buying activity remains low.

Though overall guidance is running positive, investors are seeing worrying signs from big-name companies that are issuing soft outlooks for the year ahead.

"CEOs might not be stating it, but with belt-tightening across the board in multiple countries, which is clearly apparent, it's going to translate into a lower revenue stream," says Kathy Boyle, president of Chapin Hill Advisors in New York. "People are going to be more cautious about everything, whether it's buying a computer or whatever."

Tuesday featured a busy earnings day, with Dow components DuPont , McDonald's and Johnson & Johnson reporting earnings that looked good but failed to generate much investor enthusiasm. Wednesday was no better, with Boeing beating estimates but offering disappointing guidance.

The companies struggled to post gains, while the broader market fell amid concerns that negotiations over Greek debtwere falling apart and the U.S. economy is stumbling.

"These types of markets are priced for perfection, which also means they are primed for disappointment," says Walter Zimmerman, senior technical analyst at United-ICAP in Jersey City, N.J.

Zimmerman points to metrics such as leading economic indicators from the Organization for Economic and Community Development showing readings indicating trouble head.

"The big risk to the U.S. economy really is not earnings but the situation in Europe," he says. "Current earnings are looking at the rearview mirror, at an economic situation that no longer exists. With Europe sinking back into recession, present earnings are highly unlikely to be indicative of future results."

Investors, then, simply could choose to disregard earnings until more economic visibility becomes available.

"We're looking at earnings as indicators," Zimmerman says. "From an economic standpoint, that's not really relevant for the outlook from here."

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