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 May 2010 Earnings Power
Last year stocks often jumped when losses were less than expected. Late in the year, more companies enjoyed actual profits, but they weren't coming form top line growth but rather cost cutting -- often additional layoffs. The market can only run on promises for so long. At some point, real earnings -- those stemming from top line sales and revenues -- have to emerge to sustain the bull market. Now with the first quarter of the New Year behind us, it's time for firms to either put up or shut up. It's time to see real earnings growth.
Surprisingly Good News
Ironically, Goldman Sachs, Congress' scapegoat for the 2007 - 208 financial crisis, sparked the recent optimism by reporting a 91 percent improvement in net profits. But the gains haven't been limited to the Financials. Apple's quarterly earnings jumped ninety percent as everyone snapped all sorts of i-Stuff. Others enjoying earnings powered rallies include Harley Davidson, Starbucks, United Technologies, and Boeing. How's that for broadly diversified leadership? This is encouraging for two reasons. First, it is broad based. Although Financials and Tech are leading the charge, as you can see from the list above, improvements cross virtually all sectors. This is typically what happens during a true earnings recovery in the midst of a real bull market. Secondly, and more importantly, there's a noticeable return to top-line growth. Rather than simple cost cutting, first quarter profits are tending to come from increased sales and revenues. There are only so many costs to cut (and employees to lay off), but sales and revenue growth are virtually boundless. These are more sustainable and sources of true earnings growth. This all bodes well for stocks. After the massive gains of 2009, investors are starting to wonder if there's any gas left in the tank. Without earnings support, this is a major concern. But first quarter earnings suggest support has finally arrived. Unfortunately, this doesn't mean it's 1998 all over again. There are a number of reasons to be bullish, but cautious as well. In the words of Ronald Reagan, "Trust, but verify." In the past, the strongest gains in a bull market came in its first year. That's precisely what happened in 2002 - 2003 when the prior bear market ended. If that holds true this time, the first year of the bull market is already over -- it ended last month. Historically after that point, the stocks continue to move up, but at a much slower pace with growing volatility. That's what's been happening for the past month or so, and could continue right through the summer. There still hasn't even been a mild correction in the run-up so technically, we're long overdue. It wouldn't be surprising to see that during the low trading volume of the coming summer.
Climbing Price Levels or Level Prices? According to the minutes of the March 16 Federal Open Market Committee meeting, “Participants saw recent inflation readings as suggesting a slightly greater deceleration in consumer prices than had been expected. In light of stable longer-term inflation expectations and the likely continuation of substantial resource slack, they generally anticipated that inflation would be subdued for some time."
Rising inflation often marks the later states of an equity bull market, so the longer it can be held at bay, the longer the market can run. The Fed apparently feels it's not yet a concern -- the best possible reading for stocks.
The Fed's easy credit approach is beneficial to both stock and bond investors. Low interest rates spur credit and debt financing, boosting corporate profits. Once again, these are the type of earnings that are both real and sustainable. Bond investors don't necessarily stand to gain in a low interest rate environment, but they also don't risk losses resulting form rising interest rates. As prevailing yields rise, the value of existing bonds with lower coupons decline. As long as rates stay low, this is not a problem. It's only when rates start to rise that fixed income investors need to worry
Politics as Usual Earlier this year, the benchmark 10-Year Treasury Note yielded around 3.3 percent, but recently it's been trading in the 3.8 - 4.0 percent range. As more Treasuries hit the market, look for it to move over four percent in the next few months. With the need for more government borrowing, the yield could continue to rise well in to the foreseeable future. This is significant for two reasons. First, mortgages, the lifeblood of the struggling housing market, are tied to the 10-Year Treasury yield. As its rate rises, higher mortgage rates will too, resulting in a major drag on housing sales and refinancings. So far in the current recovery, housing has been the lagging area of the economy. Any additional impediment will prolong the current problems, negatively impacting consumer sentiment. Secondly, as fixed income rates rise, bond will eventually become a formidable alternative to stocks. Until now, stocks have been the only game in town in this economic recovery. Higher yields will make bonds more attractive as alternatives to stocks. This is particularly true for conservative investors and those who are concerned that the equity market has run its course. Any reduction in demand for stocks will make additional equity gains more difficult to obtain.
It's a Small World After All In late April, the Greek government had to ask the European Union (EU) and the International Monetary Fund for assistance in order to avoid national bankruptcy. A number of analysts draw parallels between the level of Greek debt and that mounting in the U.S. This is something long term investors need to at least consider before adding U.S. equity exposure. Aside from debt, foreign economies are still struggling to boost economic growth. First quarter United Kingdom GDP was up 0.2%, half the 0.4% expected. Economic activity throughout Europe remains sluggish relative to that in the U.S. A growing number of U.S. companies rely on foreign sales for a greater and greater percentage of their earnings. The longer our trading partners remain mired in recession and the euro remains weak versus the dollar, the greater the impact on U.S. firms -- and their profits and share prices. Today's equity investor can't just follow the U.S. market and specific domestic stock fundamentals. Instead, he or she must keep an eye on the politicians, the economy, and foreign markets, too. Improved first quarter earnings are certainly a positive sign, yet stocks still face a rocky road ahead. The bull can keep running, but there are a lot of things that can slow or even stop it. Search this site! Just enter you key word or words:
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OR THE BETTER PART OF THE last year, economists have been telling us the recession has ended. Home sales, employment, and retail sales indicated otherwise. Despite the sharp equity run-up in 2009, earnings have not been encouraging, and investors have to believe there is a positive relationship between them and share prices.
