Will First Quarter Earnings Support Today's Stock Prices?

Earnings for the first quarter of 2010 look to be boffo. At least that's what Business Week is saying when it suggests that the S&P 500 companies are expected to report nearly a 32% rise in their earnings for the first quarter of 2010 versus a year earlier.

That growth is slightly less than the 40% rise in the S&P 500 index ($INX) since President Obama was sworn into office. So the big question is, do stocks have further to go? Or does that 40% rise in the S&P reflect all the earnings growth we can expect?

Earnings Looking Good

Before addressing this question, let's take a closer look at those earnings forecasts. Business Week reports that analysts surveyed by Bloomberg expect Q1 2010 earnings for large-cap S&P 500 stocks to rise 31.7% from a year earlier, and for their sales to climb 10.5%.

But not all industries are expected to do well. Bloomberg suggests that the materials sector will enjoy a mind-boggling 195% rise in earnings, from $1.69 billion to $4.98 billion. But telecommunications earnings will suffer a 4.2% drop, while utilities will crawl south by 1.6%. And financials will be somewhere in the middle -- enjoying a 28.3% earnings pop to $5.16 billion.

Room to Run

If you follow the Price/Earnings (P/E) to Growth theory, known as PEG, it looks like stocks have further to rise. PEG theory holds that if you divide a stock's P/E ratio by its forecast earnings growth and the result of the calculation is less than 1, then the stock is probably priced reasonably and may even be under-valued.

The P/E of the S&P 500 based on recent earnings is a 23.6. While that's high by historical standards, the PEG ratio of 0.64 -- dividing the P/E of 23.6 by the 31.7% earnings growth -- is less than 1. So the question for investors is how long that earnings growth can continue and which industries and companies have the lowest PEG ratios.

If you believe Bloomberg's analysts, stocks may top out sometime in 2011.That's because analysts predict S&P 500 earnings to rise 28.3% in 2010 and another 20.5% in 2011. They believe that 2011 will mark a record year for earnings -- topping 2006's record of $628.8 billion by $59 billion.

Plugging these numbers into the PEG formula would suggest that the S&P 500 trades at a PEG of 0.83 on 2010 earnings growth and a PEG of 1.15 on 2011 growth.

Where to Hunt

Based on that, I would start looking for opportunities in specific sectors, starting with materials. One such stock is Potash (POT) which trades at a reasonable PEG of 0.84, based on a P/E of 35.2 and earnings expected to grow 42% to $7.75 in 2011.

Of course, none of these earnings forecasts is a sure bet. So if you put money down, make sure you have a margin of error.