Earnings Jump, the Market Yawns
The market has turned a deaf ear to a plethora of positive earnings announcements.
This week, the market continued to focus on a handful of economic indicators while turning a deaf ear to a plethora of positive earnings announcements. The muted reaction to earnings was predictable, especially when you consider that stocks were already flying 60% higher than their March lows. After better-than-anticipated releases in each of the prior two quarters, Wall Street did a terrific job of "anticipating" a third consecutive quarter of better news. Hence, robust earnings did not necessarily translate into a vigorous market rally.
I remain optimistic about the economic recovery over the next year. In my opinion, equity analysts continue to underestimate the potential improvement in earnings during the year ahead. However, the market and portfolio managers are more bullish, pricing in more serious improvements than analysts. However, I think the market still has plenty of potential upside, especially if job creation or consumer spending start to show some long-awaited signs of life.
Housing Recovery on Hiatus?
This week, real estate announcements dominated the macroeconomic reports with what appeared to be disappointing housing starts and soaring existing home sales. After several months of steady increases, housing prices showed a modest 0.3% decline during September. While I'm not calling for the roof to cave in, I expect housing statistics to be a bit sluggish over the next several months, driven by normal seasonality and the potential expiration of the housing credit. With housing starts holding at 20% or so off the bottom, residential construction will no longer be a drag on employment or GDP. As I see it, retail spending over the next few months will carry considerably more weight than small undulations in the housing numbers--that is, unless the housing market goes into another free-fall, which isn't in my crystal ball.
Housing starts had that not-so-fresh feeling, notching a lackluster 0.5% increase. This was uninspiring, especially given that the preceding month's starts were revised sharply downward. Our housing analyst, Eric Landry, surmised that the upcoming expiration of the first-time home buyers credit caused some of the weakness. If a buyer broke ground on a new home today, it probably wouldn't be move-in ready by the December deadline the credit requires. Right now, a first-time buyer would be better off purchasing an existing home to qualify for the credit. Sure enough, Friday's figures showed that existing new home sales spiked 9.4%. The buyers' credit, as well as processing delays that moved some sales from last month to this month, were responsible for some of the improvement.
Despite seasonal adjustments, housing prices are usually stronger during the spring and early summer, and weaker during the fall and winter months. After posting three consecutive months of improvement, home prices slipped 0.3% in August according to the Federal Housing Finance Agency. Prices were down 3.6% over the last 12 months, and off 10.7% from the 2007 highs. Price movements are more restrained in this index than some of the other indexes. The FHFA index includes only home mortgages sold or guaranteed by Freddie Mac (FRE) or Fannie Mae (FNM). The regional data showed that markets hit the hardest this recession, the West and the Pacific West, both managed to show increases for August. Meanwhile, New England and the Mid-Atlantic regions demonstrated some weakness after exhibiting relative strength throughout most of the recession.
Leading Indicators Up
The index of leading indicators registered its strongest reading since 1983, potentially indicating that an incipient recovery just might have legs. Eight of the 10 metrics in the index are trending mercifully in positive territory. I believe one of the remaining indicators, hours worked, is likely to have turned upward in October after taking a dip in September.
Earnings Hitting High Notes
The earnings chorus from the corporate suite is hitting high notes almost across the board. Unfortunately, a large proportion of the improvement we're hearing about comes from cost- and labor-cutting maneuvers rather than a sharp improvement in sales, which we think is a more sustainable driver of profitability.
However, size and frequency matter with a lot of things in life, and positive revenue surprises are no exception. We're glad to be seeing more of them in the parade of third-quarter earnings announcements. High profile names like Apple (AAPL), Microsoft (MSFT), and Amazon (AMZN) all had substantial revenue surprises this week. On the manufacturing side, current revenues remained ho-hum but the earnings components were substantially better than expected. In many cases the manufacturers did raise both their revenue and earnings outlooks for 2010 and 2011, including such indicative names as Caterpillar (CAT) and 3M (MMM).
On the negative side of the ledger, the depressing effects of the year-over-year appreciation of the dollar weighed on some corporate results during the third quarter. Reductions in inventories at dealers, distributors, and even customers also damped demand a little more than I would have expected. Look for a rebuilding of inventories and a reversal of the dollar to drive fourth-quarter results significantly higher, and with a flourish. Given last year's fourth-quarter weakness, the upcoming December quarter will feature a lot of companies with double-digit earnings growth.
Forward-looking comments from the C-suite were more upbeat than they have been the past several quarters. Most managers declared an end to the recession with all the appropriate caveats. The obvious lesson from this slowdown is that the public pronouncements by public companies of improving conditions come too late to be of much help to the investing public. It's not in a company's best interest to declare things better when there is any residual uncertainty clinging to the rafters. Why would managers go out on a long limb when it brings little gain if they're correct and certain pummeling if they're wrong?
As good as I believe the third quarter's results were, revenues and earnings were still down from the previous year in many cases. If the numbers are still down, how can I be gushing with such gusto? Analysts and economists do look at how the numbers stack up against the comparable period a year earlier, but how do things look compared to the quarters immediately preceding the current one? Analysts refer to this as a sequential comparison, which paints a different picture than a comparison to the year-earlier period.
To get a full picture of a September-quarter earnings report, I need to look at not only last September's results, but also the June quarter's results, too. I want to see a sequential improvement from June; Q3 2008 results are in the rear-view mirror. However, the analysis of the numbers is more a matter of art than science. One shortcoming of sequential analysis is that it fails to take into account seasonality that is very pronounced in sectors such as retailing. Sometimes, by looking at a string of year-over-year changes, it's possible to see improvements. If year-over-year sales were down 20% during the June quarter (compared with the same period a year earlier), and down 10% during the following quarter ending in September, I would infer that there had been a substantial improvement in the trend. So, if a news headline trumpets, "Earnings Down 25%, Stock Soars," don't fall into the trap of thinking that the author is the master of spin. Expectations and choice of comparative benchmarks make all the difference when judging the numbers.
There's no shortage of economic data coming down the pike next week, including the all-inportant first report on third-quarter GDP. My expectation is that real (adjusted for inflation) GDP growth could exceed 4%. However, the inventory component is subject to very wide swings, and the exact impact of the Cash for Clunkers program means the number could range anywhere from 3% to 5%. The average expectation according to the Wall Street Journal was for flat third-quarter growth as recently as June 2009. I suspect Wall Street may be proven just as wrong for other metrics, including employment and consumer spending during the months ahead.
Durable goods orders should show some improvement, while the volatile transportation component could make the composite number's real meaning a bit fuzzy.
Watch for personal income and spending data as well. I suspect the overall savings rate might have notched another gain during September after a recent soft streak.
The Case-Shiller Home Price Index will also be released next week and is likely to eke out one more month of gains. After this release, look for normal seasonality and expiration of a housing credit to weigh on this index.