Earnings season: Will stocks justify their valuations?

After the close of market on Wednesday, the aluminum giant Alcoa (AA) will report the results of its 2014 third quarter, marking the unofficial beginning of earnings season. There is a lot at stake this time around, as five years into a bull market, average stock valuations are in high-normal range, which admittedly means that we won't know whether they were really “high” or “normal” until we see where the market goes from here.

The recent market selloff may be a blessing for investors, as it has brought the average P/E Ratio of S&P 500 stocks down to 18.68, where it had been nearing 20. Most analysts agree that anything north of 20 means stocks are in a rather pricey neighborhood, though at 18.68, there is still some wiggle room. If the major players beat the Street's earnings forecasts and, just as importantly, provide forward guidance that meets or exceeds analyst estimates, then stocks will continue to look very attractive at this level.

The worry – and there is plenty of that this time around – comes from several factors. First, there is America's still weak job market, which, though it is now creating jobs, also seems to be funneling more and more workers out of upwardly mobile middle-income jobs and into go-nowhere low income jobs, creating, in the process an ever expanding class of working poor. This isn't the group that buys iPhones on launch day, and while that sounds petty, it represents exactly the sort of consumer discretion that many companies depend on – and exactly the sort that the Street, by giving stocks such high valuations, has bet on.

Then there is the global economy. Europe, after long being carried by mighty Germany, is in serious trouble now that Germany's economy seems to have stalled out. China is sliding, slowly but inexorably, toward a debt crisis that could prove agonizingly deep. And of course, far too much of the world is wracked by conflict, creating tremendous uncertainty.

Most analysts are expecting good news from Alcoa, but since most analysts are taking their views directly from other analysts, that doesn't mean much in itself. In this case, however, the reasoning is both simple and sound: the global price of aluminum has been rising, and strongly – 93% in the last 12 months. Given the high expectations created by expensive aluminum and three recent analyst upgrades, it is hard to believe Alcoa wouldn't have said something by now if things weren't going well.

Tomorrow, the Street will hear from Family Dollar (FDO), Safeway (SWY) and Pepsico (PEP). Watch closely. I'm not worried about Pepsico, but if Family Dollar and Safeway stumble, it means the consumer is stumbling. In that event, investors may wish to start hedging their bets, because we will certainly be in for a bumpy ride. 

Julian Close has been a business writer since the first day of the twenty-first century, having written for PRA International and the United Nations Department of Peacekeeping. He graduated from Davidson College in 1993 and received a Master of Arts in Teaching from Mary Baldwin College in 2011. He became a stockbroker in 1993, but now works for Fresh Brewed Media and uses his powers only for good. You can see closing trades for all Julian's long and short positions and track his long term performance via twitter: @JulianClose_MIC.

Julian Close

Julian Close

Julian Close became a stockbroker in 1995. In his 20 years of market experience, he has seen all market conditions and written about every aspect of investing. Julian has also written extensively on corporate best practices and even written reports for the United Nations. He graduated from Davidson College in 1993 and received a Master of Arts in Teaching from Mary Baldwin College in 2011. You can see closing trades for all Julian's long and short positions and track his long term performance via twitter: @JulianClose_MIC.

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