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.
