Corporate Profitability Is the Real Problem

Several months ago I wondered aloud whether the current rally had legs based on Q1 corporate earnings (see Are Better-than-Expected Earnings Illusory? or Corporate Earnings Redux). I concluded in June:

The key then to the future of corporate profitability lies in whether you believe corporate earnings have bottomed out and will now begin to increase from a lower base, or whether you believe that there is still substantial downside risk that increasing unemployment and decreased consumer spending will continue to put a crimp in profitability. Given the nearly 40% rally in equity markets over the past several months, market participants clearly believe the former. I fear that the latter might be more representative.

Markets have continued to rally since June, and were up more than 50% from the March lows. But Q2 earnings looked no different than Q1. The story, again, was better-than-expected earnings based off greatly reduced earnings expectations, and greater-than-expected cost cutting. There was not much revenue growth; instead, revenues broadly declined.

Given the lackluster nature of corporate profitability, many have now begun to question the underlying rationality of the rally, including the following thought-provoking piece from this week’s edition of The Economist (see Has the Tide Turned for Corporate Profits?). According to The Economist:

The recent rally in shares has been driven…by hopes of economic recovery. But if those recovery hopes do not translate into a rebound in profits, it is hard to see how the rally can last.

The American second-quarter results season was undoubtedly better than expected. But it is worth remembering that such positive surprises are quite common, with companies massaging down expectations in the run-up to their figures. David Rosenberg of Gluskin Sheff, a Canadian asset-management firm, says profits were actually down 27.8% year-on-year…

MY ADDENDUM: Again, it’s not simply that companies/analysts ratcheted down expectations leading to better-than-expected earnings, but that companies beat expectations due, in large part, to greater-than-expected cost cuts.

With profits still falling, the rally has thus been driven by a re-rating of the market. Assuming operating earnings hit $50 a share in the third quarter, the S&P 500 index is trading on a price-earnings ratio of 20, the kind of multiple normally associated with boom conditions. Clearly, investors are expecting a robust profits recovery in the years ahead.

But companies are digging themselves out of a deep pit…

It is this deep pit that should be most disconcerting. And again, it all comes down to the assumptions that you are willing to make about how quickly firms are likely to emerge from that pit. Some expect demand to increase rapidly, leading corporate profitability to snap back (at least that’s how the market seems to be pricing it). But given the precarious state of consumer balance sheets, top-line growth drivers are less than obvious to me, …Even if we are experiencing something of an economic recovery. Moreover, cost cutting is not a sustainable path to profitability. For these reasons I remain less sanguine than most about the speedy return of corporate profitability.

Comments

[User 353732:]

1. The point of the equities rally is to create an exit strategy for Big money at the expense of Retail money. The Inside money does not care how the rally is manufactured just as long as the Outside money can be deluded into beleving that stocks are "cheap" and "this is a once in a generation opportunity to get in at the bottom to recoup all the losses of the past decade". The valuation metrics need not be based on historical consistency: they need only be convincing, for a season, to retail investors.
2. A great majority of retail investors have seen no net gain in their stock portfolios for about 10 years, including dividend reinvestments. Tens of millions of baby boomers are getting very anxious indeed, financially, and millions of older Americans are becoming desperate for either higher yields or capital enhancement as they face suddenly very bleak remaining retirement years.
For Wall St this represents a glorious combination of fear and greed , which truly occurs but once in a generation. It is simply too fine an opportunity to miss: simultaneously monetize the greed for more income(induce retail investors to" trade" in the hope for a quick profit in 6 to 9 months) and fear about retirement funds(induce the herd to inject even more money into tattered stock portfolios for long term gains from a low base in 2009....)
3. Given the objective is to monetize fear and greed, any valuation metric will do that works;
if earnings have plunged and P/E ratios are absurdly high, then switch to "anticipated earnings"; if these are simply too meager ( after, not all Managements are prepared or inclined to lie to pander to Wall St ); then switch to multiples of cash flow;
if cash flow looks shaky then trot out multiples of revenue ; if revenues are 20% to 30 % below last year, then immediately tout the invisible amazingly strong and rapid recovery( the great "V") and the "anticipated" strength in exports and 2010 revenues; next tell people that as revenues soar in the near(but not too near) future income and dividends will soar even higher and, based on the layering of vapor on fantasy on fabrication , stocks are really, honestly, just too cheap to resist.
Finally, if recalcitrant Main St investors still wont buy early and often, simply invent the "coming boom in M&A fueled by vast amounts of hoarded corporate cash, efficiency and the resurgence in global private equity as the appetite for risk returns with power and might".
Even better, if the bewildered, frightened and greedy retail investor has no notion what this means or has any ability to verify any part of this marketing statement.

Sep 02 06:00 AM

[Moon Kil Woong:]

If you want rising profitability in your portfolio I would suggest buying companies located overseas and/or companies that sell overseas. So far, they are the only ones (save the banks or government darlings that get direct monetary infusions) who are really benefitting from government spending which has largely resulted in dollar depreciation.

Domestic growth has yet to be seen.

Sep 02 07:49 AM

[willynill:]

User 353732 has nailed it. He is exactly right.

Sep 02 08:45 AM

[CautiousInv...:]

Yesterday PIMCO reminded us of the new normal.

For investor's one of the more salient features of the new normal will be depressed profits owing to reduced financial leverage, hidden costs in various reforms under consideration, lower growth, likely repeal of a host of tax deductions and the choke hold of heightened regulation.

Implicit within the framework of the new normal is a reduction of final demand and a belief there will sub-par job creation. I agree with this and add that in the recent past we had science to help us out........Bell Labs, RCA, Xerox PARC, DARPA, and NASA......and from this we gave birth to a suite of industries including the PC, Internet, Internet infrastructure and cellular industries, all born in the 1980's and 1990's.

Some of these institutions, though, are gone and the remaining ones have been gutted, leaving a weak foundation to grow new industries. More recently, though, small businesses have picked up the slack and served as our engine of growth but under the environment of the new normal this will be no longer the case.

In addition to not having an incentive to save and invest, small businesses, who are primarily owned by Republicans, are being decimated through an inability to secure credit at a time when large suppliers are demanding prompt payment and large customers are delaying payment.

Sep 02 08:58 AM

[LKofEnglish:]

let's see--TRILLIONS in stimulus. DOUBLE DIGIT unemployment. A COLLAPSING dollar and a real estate market that is DEAD but which this nation's CENTRAL BANK has committed 100'S OF BILLIONS towards "propping up." If you can't more money than you can shake a stick at in this economy then you really shouldn't be in business at all. Did I forget the word MONOPOLY? You might not be roaring out of this recession but I sure am.

Sep 02 04:52 PM

[Manifestor:]

Companies profitability is decided more by their sales overseas as the share of US economy in global economy has shrank significantly. One needs to travel around to see how the rest of the world has turned around and started thriving.

Moreover, time is getting very ripe for M&A activity as companies are lean and mean, with hoardes of cash and the most prudent way for them to expand is to acquire weaker companies which are themselves lean and mean thanks to relentless layoffs.

In short, this is going to be a jobless recovery but recovery and rising markets nonetheless.

Employment in US will rise only when innovation takes hold and we get some breakthrough technology either in energy, stem-cell/biotechnology or information/computer technology or some such. This cannot be predicted. Big companies are not incentivized enough to promote innovation. They only have to ddeliver profis and profit growth which they can do through cost cutting, expanding customer base and buying other companies.

In the mean time, to user 353732's comment, at this moment it looks like the Big Money are not just all the big houses but all those willing to see beyond the current malaise namely the risk takers, and the Outside Money (Retail Money) are the Perma Bears of the SA and other similar communities! When finally the bears break down will be time to sell.

Sep 02 10:19 PM

[Nick36:]

A lot of investors chose to ignore the poor P/E ratios of the stock market because they were expecting a V-shaped economic recovery in the second half of this year.

The second half of this year still has four months to go. And if that V-shaped economic recovery doesn't come soon. Then many investors who drove the rally will probably reconsider their investment positions and bail out.

The reported P/E of S&P500 is now 129.19
www2.standardandpoors....

Which is equivalent to 0.77% yield on your stock market investment. And unless the earnings of companies improve dramatically, it doesn't make sense to stay invested in the stock market for the long term with this kind of yield.

You can get a better yield than this by keeping your money in cash in an FDIC insured bank account, with virtually no risk of loosing your money.

Sep 02 11:07 PM