Thursday, July 8, 2010

Earnings Jump... Cause for Economic Concern?

The Good: Earnings are up.

As Doug Kass detailed Wednesday morning (with what appears to be some great timing), this may be reason to believe that stocks have hit bottom for the year:
Trading at around 11 times earnings, stocks are fairly inexpensive, says Kass. He notes stocks generally trade at around 15 times future earnings, and even higher in periods of tame inflation and low interest rates, as we're currently experiencing.
Rather than P/E ratio, below is E/P (i.e. earnings yield) of the S&P 500 going back 100 years (note that earnings yield appears to be at a 20 year high).

The Bad: Earnings are up.

The important question is how these earnings have come about. We all know that recent earnings have ratcheted higher due to reduced costs (job cuts, lack of investment, cheap financing) rather than top line growth. In other words, executives for public firms have caught up with the "buy, strip, and flip" nature of private investors. Yves Smith and Rob Parenteau detail the impact on the "actual" economy:
The big culprit in America is that public companies are obsessed with quarterly earnings. Investing in future growth often reduces profits short term. The enterprise has to spend money, say on additional staff or extra marketing, before any new revenues come in the door. And for bolder initiatives like developing new products, the up front costs can be considerable (marketing research, product design, prototype development, legal expenses associated with patents, lining up contractors). Thus a fall in business investment short circuits a major driver of growth in capitalist economies.
And a similar story from the Chicago Tribune, Corporate Spending Good for Economy, but Bad for Profits, with a focus on the analyst community.
But even optimistic analysts, those who have ruled out a double-dip recession and see growth continuing at a modest pace, are wary. Some are raising concerns that companies will fall short on the profits investors are expecting, and they think the recent sell-off in the market comes from investors afraid to wait.

The cautious stance is not merely a symptom of global economic worries. Rather, some analysts contend that companies now must spend more money if they are to increase profits at levels that will satisfy investors. Yet, if they are spending more, and a weak economy stifles sales, that spending could backfire, leaving companies with disappointing profits and disappointed investors.
Source: S&P / Irrational Exuberance