So far this week, we have seen Goldman Sachs report a record profit through the second quarter while Dow Jones Industrial Average components Intel and Johnson & Johnson both beat analyst expectations with their own numbers.
Beyond officially marking the beginning of earnings season, these few companies have set the tone for investors. With such a strong start, market participants will expect a strong rebound in earnings across the board. Optimism and risk appetite have already been driven higher on just such an outlook so far this week; and equities, currencies, commodities and fixed income have all reflected the shift. However, will the wave of accounting be as consistent as this rally in the markets would suggest? More importantly, is an expected rebound in income necessarily a clear catalyst for long-term bullish trend change? We need to look at this data and its potential for market movement more closely.
[B]A Rebound in Earnings Does Not Necessarily Mean a Rebound in Growth[/B]
It may seem a clear signal that a recovery in revenues for corporations is a sign that the economy is recovering and financial conditions have normalized. However, one does not lead into the other so easily. A rebound in earnings has been expected – and not just according to analysts’ consensus forecasts. In the grander scale of things, a color change in corporate bottom lines is inevitable after such a sharp plunge into recession as cost cutting efforts and a stabilization of demand push earnings per share (EPS) back into the black. From this standpoint it is a little clearer that positive accounting does not directly translate into growth – rather this is actually more like GDP data: it hasn’t returned to positive territory but has eased its pace of contraction.
Seeing strong earnings and company expansion is likely a ways off. Demand is still a missing component. The IMF expects the global economy to 1.4 percent this year before returning to growth of 2.5 percent through 2010. In the meantime, consumer spending will dampen the rebound for production. In the world’s largest economy – the US – the FOMC estimates the nation’s unemployment rate will hit 9.8 to 10.1 percent. What’s more, a lack of liquidity outside the circle of the core financial players means investment will remain anemic.
[B]The Health of The Financial Leaders[/B]
There will be a particularly sharp focus over the next few weeks on the banking sector. This sector has been at the center of the original meltdown (the subprime collapse) and has spurred on the biggest crises along the way (like the Bear Stearns, Lehman Brothers and AIG failures). Therefore, it makes sense that this specific sector will be the litmus test for the entire season. If the banks, insurers, money managers, and other financial firms cannot pull themselves up; the specter of another bankruptcy could threaten to destabilize the financial system once again. Government’s are already scraping the bottom of the barrel in terms of liquidity; and further bailouts or guarantees will only go to those that hold systemic risk (just look at CIT). What’s more, tax payers will be paying particular attention to the health of those banks that borrowed money from the government to pull them through the worst. Most of those banks that borrowed TARP funds to pass the Treasury’s Stress Test have already paid the government bank. If this was more a move to appease investors than to move out of the umbrella of a conservative lender, then the companies may be in a worse situation after the cycling out the aid than before they took it. Furthermore, it will be important to take the earnings with a grain of salt. Accounting can be legally manipulated to bolster numbers and the weight of liabilities can be played down.
[B]
Blue Chips More Attuned to Growth[/B]
While bank earnings is a better reflection of the health of the financial market, the Blue Chip member companies of the Dow Jones Industrial Average will offer a better sense of general economic activity through the second quarter. This is a promising situation considering the forecasted EPS for most of those reports through the rest of the month are positive. So, while numbers can be stretched, the wider base of the industries and more direct link to consumer demand will provide the better reading on the global economy. On the other hand, the components of this benchmark equity index represent some of the largest companies in the world. The ability to continuously trim costs, rely on banding and receiving greater attention from the government means these firms could outperform smaller sized firms. This skew should be considered; but it won’t likely blur the outlook for growth.
[B]Market Impact[/B]
It will be easy to see whether earnings will impress or disappoint; but that does not mean it will be a straightforward translation into market sentiment. The response to the three major earnings releases so far this week has sparked an aggressive rally in risk appetite; but now it will the bar has been set high. Should profits at the other TARP banks (Bank of America, Citi, JPMorgan, etc) cross the wires with less pomp and circumstance, sentiment could fad and the recently developed bear trend through most of June and July could regain its footing. Investors will also look more critical to each successive release. Even if there are consistent improvements, they will be weighed for their reflection of broader economic activity and analyzed for the possibility that this is a steady improvement to be extend into the second half of this year and beyond. Sentiment has considerable nuance; and this earnings season is likely to highlight that fact.
