Corporate Profits Could Positively Surprise Stock Prices With Upside Momentum
Boo! Was that a ghost, or was that just some soft patch talk scaring you during a nightmare? The economic data hasn’t been exactly rosy over the last month, and as a result, investors have gotten spooked and have chosen to chainsaw their equity positions. Since late April, nervous investors had already yanked more than $15 billion from U.S. equity mutual funds and shoved nearly $29 billion toward bond funds (Barron’s). Jittery emotions are evidenced by the recently released June Consumer Confidence numbers (Conference Board), which came in at a dismal 58.5 level – significantly above the low of 25.3 in 2009, but a mile away from the pre-crisis high of 111.9 in 2007.
Economic Monsters under the Bed
Why are investors having such scary dreams? Look no further than the latest terror-filled headlines du Jour referencing one (if not all) of the following issues:
• Inevitable economic collapse of Greece.
• End of QE2 (Quantitative Easing Part II) monetary stimulus program.
• Excessive state deficits, debt, and pension obligations.
• Housing market remains in shambles.
• Slowing in economic growth – lethargic +1.9% GDP growth in Q1.
• Accelerating inflation.
• Anemic auto sales in part caused by Japanese supply chain disruptions post the nuclear disaster.
Surely with all this horrible news, the equity markets must have suffered some severe bloodletting? Wait a second, my crack research team has just discovered the S&P 500 (NYSE:SPY) is up +5.0% this year and its sister index the Dow Jones Industrial Average (NYSE:DIA) is up +7.2%. How can bad news plus more bad news equal an up market?
OK, I know the sarcasm is oozing from the page, but the fact of the matter is investing based on economic headlines can be hazardous for your investment portfolio health. The flow of horrendous headlines was actually much worse over the last 24 months, yet equity markets have approximately doubled in price. On the flip-side, in 2007 there was an abundant amount of economic sunshine (excluding housing), right before the economy drove off a cliff.
Being purely Pollyannaish and ignoring objective soft patch data is certainly not advisable, but with the financial crisis of 2008-2009 close behind us in the rear-view mirror, it has become apparent to me that fair and balanced analysis of the facts by TV, newspaper, radio, and blogging venues is noticeably absent.
Given the fact that the stock market is up in 2011 in the face of dreadful news, are investors just whistling as they walk past the graveyard? Or are there some positive countervailing trends hidden amidst all the gloom?
I could probably provide some credible contrarian views to the current pessimistically accepted outlook, but rather than recreating the wheel, why not choose a more efficient method and leave it to a trusted voice of Scott Grannis at the Calafia Beach Report, where he resourcefully notes the market positives:
“Corporate profits are very strong; the economy has created over 2 million private sector jobs since the recession low; swap spreads are very low; the implied volatility of equity options is only moderately elevated; the yield curve is very steep (thus ruling out any monetary policy threat to growth); commodity prices are very strong (thus ruling out any material slowdown in global demand); the US Congress is debating how much to cut spending, rather than how much to increase spending; oil (NYSE:USO) prices are down one-third from their 2008 recession-provoking highs; exports are growing at strong double-digit rates; the number of people collecting unemployment insurance has dropped by 5 million since early 2010; federal revenues are growing at a 10% annual rate; households’ net worth has risen by over $9 trillion in the past two years; and the level of swap and credit spreads shows no signs of being artificially depressed (thus virtually ruling out excessive optimism or Fed-induced asset price distortions). When you put the latest concerns about the potential fallout from a Greek default (which is virtually assured and has been known and expected for months) against the backdrop of these positive and powerful fundamentals, the world doesn’t look like a very scary place.”
Wow, that doesn’t sound half bad, but rock throwing Greek vandals, nude politicians Tweeting pictures, and anti-terrorist war campaigns happen to sell more newspapers.
It’s the Earnings Stupid
Grannis’s view on corporate profits supports what I recently wrote in It’s the Earnings, Stupid. What really drives stock prices over the long-term is earnings and cash flows (with a good dash of interest rates). Given the sour stock market sentiment, little attention has been placed on the record growth in corporate profits – up +47% in 2010 on an S&P 500 (NYSE:SPY) operating basis and estimated +17% growth in 2011. Few people realize that corporate profits have more than doubled over the last decade (see chart below) in light of the feeble stock market performance. Despite the much improved current profit outlook, cynical bears question the validity of this year’s profit forecasts as we approach the beginning of Q2 earnings reporting season. However, if recent results from the likes of Nike Inc. (NYSE:NKE), FedEx Corp (NYSE:FDX), Oracle Corp. (NASDAQ:ORCL), Caterpillar Inc. (NYSE:CAT), and Bed Bath & Beyond Inc. (NASDAQ:BBBY) are indicators of what’s to come from the rest of corporate America, then profit estimates may actually get adjusted upwards…not downwards?
There is plenty to worry about and there is never a shortage of scary headlines, but reacting to news with impulsive emotional trades will produce fewer sweet dreams and more investment nightmares.
Wade W. Slome is a CFA and CFP® at Sidoxia Capital Management.
Disclosure: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing SCM had no direct position in TROW, or any other security referenced in this article.
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