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Profits Are at Record Levels, So Why Aren't Stock Prices?

With almost all of thethird quarter results out, it’s safe to say that companies in the S&P 500Index have achieved record earnings and profit margins on a quarterly and one-year basis, fully exorcising the 2008 credit crisis and reflecting the aggressive cost cutting efforts underway since that calamity.

NYSE trader
Photo: Oliver P. Quilla for CNBC.com
NYSE trader

“Third quarter 2011 establishes a new quarterly and trailing four quarter EPS peak while trailing four quarter net margins remain at peak levels,” according to a Goldman Sachs Research, which came to this conclusion using the figures from the 90 percent of the S&P 500 members that have reported and the firm’s estimates for the rest.

“The last four quarter EPS total of $94.80 (for S&P 500) exceeds the previous peak of $91.47 achieved in second quarter 2007,” Goldman Sachs said.

Midway through 2007 marked the implosion of two Bear Stearns hedge funds, a precursor to the collapse of the housing bubble that culminated in the bankruptcy of Lehman Brothersat the end of 2008 and one of our deepest recessions since The Great Depression. The S&P 500 hit an all-time high in October 2007.

So if stock prices are a reflection of future earnings, why hasn’t the U.S. benchmark returned to this record high yet? Currently, the S&P 500 is 20 percent below that 2-year old peak.

“The expectation is that earnings may decline if Europe can’t get out of its own way,” said Karen Finerman, president of hedge fund Metropolitan Capital Advisors.

In other words, investors aren’t willing to pay as much for these earnings this time around with a possible European recession set to depress the future profits of U.S. multinationals, not to mention gum up the international banking system. The S&P 500, at a price-earnings ratio of 12.1, is near its lowest valuation of the last decade.

Goldman’s David Kostin, the portfolio strategist who authored the report, believes the S&P 500 will fall to 1200 by the end of the year and end up slightly higher from current levels by the end of 2012 to around 1300. In the report he cites weak guidance from companies during this third quarter earnings season.

Companies are sitting on a record cash hoard that they have started to deploy on buybacks and dividends, but have yet to use to hire more employees. Jobs datareleased Friday showed a 9 percent unemployment rate. Average profit margins in the S&P 500 are at a peak 8.9 percent, according to Goldman.

“You want to buy depressed profit margins and sell record ones as it’s a mean reverting statistic,” points out Peter Boockvar, equity strategist at Miller Tabak.


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