Revenues vs. Earnings

The S&P500 jumped almost 7% last week, reversing much of the drop from the preceding four weeks.  Volatility fell, driving down the cost of insuring against a drop in the equity markets. 

Positive economic data did not drive the rally.  The Treasury’s borrowings came in worse than expected.  All inflation reports were within reasonable ranges–not too hot, not too cold.  Capacity utilization and industrial production continued their downward slide.  Initial claims were better than expected, BUT they were seasonally adjusted (to the positive) to account for the usual automotive layoffs that occur during this time of year.  They didn’t occur, so initial claims were distorted by the government; look for a return to more normal initial claims in the upcoming weeks.  Continuing claims dropped off, but not because the unemployed were finding jobs; more likely because their benefits were expiring.  Housing starts and permits were better than expected, but still near multi-decade lows, as one would expect when the housing market is still imploding. 

Technically, last week’s rally was not enough to reverse the weekly charts; they’re still weak.  The daily charts, clearly pointed up, but because the S&P returned to an overbought region (940), further upside movement is not a given.  The monthly perspective is still solidly in bearish territory.

So what sparked the rally?  One commonly cited reason was that Q209 earnings from several bellwether firms surprised to the upside.  If the economic recovery is happening, then one would expect earnings to beat consensus forecasts.  Some did.  All is good, right?

In a word, no.  First, many earnings forecasts (conjured up by the same sell-side, bottom-up analysts who were dead wrong about earnings in 2008) were set so low that beating them was not the great success that some in the mainstream media claimed. 

Second, and more importantly, while some major firms were beating estimates on the bottom line, they were failing miserably on the top line.  So these firms squeezed out more profits on declining revenues.

What’s wrong with this picture?  Simple logical extrapolation suggests that sooner or later, these firms will hit a wall with earnings.  If their businesses keep shrinking, they will eventually not be able to cut another employee, another lease, another capex project, etc. to be able to prop up profits.  Nobody can shrink their way to greater earnings.

And the top line erosion was scary: Alcoa (-41% yoy), GE (-17%), Intel (-15%), Marriott (-20%), IBM (-13%), Mattel (-19%). 

So the next time your financial analyst tells you: “the water is fine; go ahead, it’s OK to jump in”, ask the obvious question about earnings sustainability, over the next several quarters.  And be sure to ask about the core underlying problem of our great recession–the massive debt load carried by our private and public sectors and if it’s been fixed.

Chances are your advisor won’t even understand the questions.

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