Good New For Stocks: Earnings Expectations Look More Reasonable

It took several painful months, but signs are appearing that Mr. Market is finally figuring out what reasonable earnings expectations might actually look like.  After months of continually slashed earnings forecasts across Wall Street, Merrill Lynch says today we're emerging from a long, frustrating stretch where markets were hindered by a large number of "value traps" -- industries that appear undervalued relative to their own average market multiple, but still facing falling prices and downward earnings revisions. Three out of four times, the trapped industry will fail to outperform the market in the subsequent month, Merrill says. When an industry slips into that category, it takes an external catalyst to pull it out.

Unsurprisingly, last year there were a lot of sectors fitting that description. Merrill says 2008 was the "year of the value trap" when the number of industries in such a fix tripled. In fact, Merrill says the entire market looked like one big value trap since "the S&P 500’s forward multiple contracted but only because prices were falling faster than fundamentals were deteriorating -- typically not a good entry point for an investment."

So what's the situation now? "Today, there are only three industries that our model identifies as value traps, whereas there are five times as many industries that appear to be undervalued for potentially the 'right' reasons," Merrill says. Of those, two are showing signs of rapid improvement: Consumer staples and healthcare. They're classic defensive names that have held up modestly well compared to the rest of the market. Merrill says the pair "still offer attractive relative multiples within an historical context, and enjoy relative earnings growth and positive momentum."

With stocks selling off hard again today and indexes creeping uncomfortably close to November lows, the above is no reason to turn bullish. But any sign that Wall Street's expectations more realistically reflect the actual health of companies and the economy should be welcome.