Stocks, bonds and the earnings season dance

August 5, 2010

A look at company earnings implies it is a great time to be a corporation in America, but for investors a rising savings rate and the threat of deflation mean that, ugly and risky as they are, government bonds looks good in comparison to stocks.

So far it has been a pretty remarkable earning season in the U.S. Almost 80 percent of companies reporting have beaten analysts’ estimates and profits among the largest companies are up more than 40 percent on the same period last year.
Perhaps even more remarkably, companies are managing to trouser a record 10.2 cents in every dollar of revenue after operating costs, according to Standard & Poor’s.

That’s the rub – profitability growth is outpacing revenue growth, which has been 9.0 percent, implying that the gangbusters pace of profits is more due to cost cutting and efficiencies than a sustainable expansion in anyone’s business model.

So far, stock market investors seem to like it. The S&P 500 is up nearly 10.0 percent since its early July lows and has gained about 4.0 percent since the reporting season kicked off in earnest. Then again, earnings seasons are usually kind to stock, suspiciously kind.

It is almost as if someone pulled the plug on the feed of economic news to stock investors while allowing the earnings beat stories to keep on coming.

The real challenge for U.S. companies and for stock market valuations is how profit growth can be sustained in the face of anemic overall economic growth, if not a double dip recession.

How do you increase profits if consumers are not spending more and if they are not earning more, but are finally starting to save more. The figures really don’t add up very well.

According to the U.S. Commerce Department June household income growth was unchanged and real spending rose just 0.1 percent. Company managers may be good, but it will take a magician rather than an MBA degree to spin that straw into further 40 percent increases in profitability.

Even more significant is the increase in the savings rate, which was revised up for May to 6.3 percent from a previous estimate of just 4.0 percent and which rose again in June to 6.4 percent.

It makes sense from an individual’s perspective to be saving more, to offset losses on assets and to deleverage, not to mention as insurance against a terribly unforgiving job market. But collectively it will savage company earnings and tend to drive stock prices lower.

And then there is the threat of deflation. On the Federal Reserve’s favorite measure – the core personal consumption expenditure deflator – inflation was unchanged in June and has risen by just 1.4 percent in a year. That too spells trouble for companies and will underpin government bond prices.

This brings us to the outlook for company earnings, as seen through the prism of the sell-side analyst community. There is a funny phenomenon with company analysts. They are always terribly optimistic in the medium term – jam tomorrow – but tend to scale back that optimism as the due date for the jam to be spread today nears. That allows for companies to exceed expectations a satisfyingly happy amount of the time, which pleases the market, while investor can still contemplate a hazy but sunny vision of the future.

Andrew Lapthorne, of Societe Generale in London, tracks the change in analyst optimism, meaning the percentage of earnings forecast revisions that are upgrades, which has proven to be a strong leading indicator of economic direction. Measured on a six month seasonally adjusted basis, this indicator has turned sharply negative and is now in territory last plumbed in 2000 when the dot com bubble was busily becoming dotbust.

Still, economists are cautious people and a double dip recession is only an outside possibility, right?

“We should all know full well that the sell-side will only call the recession long after it has begun and when it is far too late,” wrote Societe Generale strategist Albert Edwards, who sees a yield on 10-year U.S. bonds below 2.0 percent eventually, down from 2.95 percent currently, and who sees a fall for equities below their March 2009 lows.

Companies, in the U.S. and elsewhere, have made a good job out of a mediocre economic recovery. Even they, though, are showing extreme caution, hoarding cash, and refinancing to ensure that the next credit crisis does not take them unawares.

I’d argue that while many are prepared to survive the worst, what won’t survive is the current relationship between stock prices and earnings. That will head south as saving grows, spending flags, and bond yields continue to fall.

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Bonds have to be the favorite with rates expected to stay low for a Real long time

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