Are These Earnings Really Cause for Celebration?

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Includes: CAT, GE, IBM, INTC, MAR, MRK
by: Graham Summers

With Wall Street clamoring about how great earnings are, it’s worth our time to examine the REAL Year over Year (YoY) results for economic bellwethers. After all, beating an estimate set so low that an earthworm could clear it is hardly grounds for a celebration. And Wall Street analysts hardly have a reputation for nailing earnings.

Indeed, Wall Street’s ability to predict earnings has been steadily worsening ever since Regulation Fair Disclosure barred CEOs and other corporate executives from revealing inside information to analysts before the general public in 2000 — yes, up until that point it was 100% legal for execs to give the Street insider information about earnings.

However, even by post-Regulation Fair Disclosure standards, Wall Street analysts’ results have worsened. Again, they were only accurate 6.7% of the time. At that point, wouldn’t it be prudent to do away with earnings expectations completely?

Apparently not. Earnings estimates continue to play a major role in the markets. In fact, much of the last two weeks’ rally has stemmed from Corporate America beating earnings estimates. Let’s have a look at the real numbers companies like Intel (NASDAQ:INTC) and GE are putting out.

Let me get this right… these results are reason for celebration?!?

Wall Street makes a big deal about earnings (earnings estimates, earnings forecast, etc), but when it comes to economic growth, sales are the more critical metric. As we noted in last week’s issue, a company can gimmick earnings through various methods. Earnings can also be manufactured by cost cutting: lay-offs, salary cuts, reduced inventory, etc.

Thus, when a company produces “better than expected” earnings, it’s not always a good sign: firing people means greater unemployment which means less consumer spending which means more economic contraction which means lower sales, which means more firings, etc.

On the note of earnings, have a look at the above numbers. Virtually every sector is posting MASSIVE drops in earnings year over year. Sure, companies ARE showing improvements from their 1Q09 results. But you have to remember the environment we were in during 1Q09. We had only just finished a stock market collapse that wiped out $11 trillion in wealth. More than 50% of US stocks were trading for less than $5 a share.

Almost two million people lost their jobs in 2008. Personal bankruptcies soared more than 27% YoY. And a record 31 million Americans were on Food Stamps. The economy, as Warren Buffett put it, had “fallen off a cliff.”

From that environment, virtually ANYTHING would be an improvement. So the fact that 2Q09 earnings are marginally better than those of 1Q09 is hardly a bullish development, let alone cause for a major rally in the stock market.

As for those claiming that the market has bottomed, consider that historically the S&P 500 has bottomed with a P/E of 10 and dividend yield of 5-6%. Today the S&P 500 has a P/E of 24 and yields 2.35%.

Looking at this, one could easily argue that the market would need to HALVE (S&P 500 at 500 or so) in order to make a REAL bottom. I think this will eventually happen, but it may take years (a la Japan in the ‘90s or the US in the ‘30s). Of course, we could also see another major crash of 20-30% (S&P 500 falling to the 600-700 range) followed by a gradual slide to the 500 range.

From a technical perspective, 70% of stocks on the NYSE are currently piercing their 200-day moving averages. The last time this happened was the summer of 2007... which was only a few months before the market hit an all time high before collapsing.

There are a few other technical “red flags.” IBM is back trading at the same price it hit in September ‘08, just before the collapse in global financial systems and economies. In fact, IBM is ONLY 18% from its all-time high in July 1999. From an index perspective, the Nasdaq has rallied for ten straight sessions. The last time this happened was July 1998 when the Tech Bubble was going in full force.

Put another way, the market is now trading as if the worst financial crisis and economic contraction since the Great Depression NEVER happened.

We’ve been in this situation before, when the market pretended Bear Stearns, Lehman Brothers, and Fannie (FNM) and Freddie (FRE) didn’t happen last year. I don’t think I need to remind anyone what happened then.

Don’t be duped by Wall Street’s earnings celebration. We’re in for a very, very nasty Autumn if this rally doesn’t cool off soon. The market can play pretend for a while… but when economic realities take hold it won’t be pretty.