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Yet another Quarter of Better-Than-Expected Earnings Growth
By: Dr. Charles Lieberman
Date: 10/19/2009
We are still in the early stages of earnings reporting season for the third quarter, but the preliminary indications suggest that corporate profits will exceed expectations for the third consecutive time, as we have been expecting. Q3 should not be a total surprise. The real surprise came in Q1, when economic growth contracted at a horrific 6% annual rate, yet profit margins increased. Now, profits are growing in response to the first signs of economic expansion. Companies have sharply reduced costs and operations are very lean. Even small increases in sales translate into solid increases in earnings, yet expectations are low. We expect more of this going forward, helping justify the sharp rally in the equities market that began in March.
The credit crisis that followed Lehman's failure sparked a sharp retrenchment in consumer spending, but also a massive increase in corporate layoffs. Firms were very aggressive in their efforts to reduce costs to preserve their businesses. Companies reduced employment significantly more than sales declined, as documented by the record liquidation of inventories in the first half of the year. It is now evident that these cuts are unsustainable. Businesses must rehire just to prevent inventories from falling even more. But before they resume hiring, it is critical that they experience some rise in sales, so they can project an economic recovery. As recovery prospects improve, hiring will pick up at a more meaningful rate.
In the meantime, profit margins have increased sharply, as costs have fallen more than sales. With a moderate increase in salesGDP is expected to rise about 3-1/2% in Q3corporate profits should exceed the modest expectations of investors. In fact, the early reports suggest that sales and operating profits are coming in nicely above expectations. The next two weeks will see an avalanche of earnings reports and we expect those to reinforce the positive message already implied by the companies that have reported.
The pickup in corporate profits has not been a total surprise to the market, as demonstrated by the sharp rally seen since the early March lows. This is actually typical for the early stages of recovery, where the equity market rallies before the economic recovery or the profits recovery becomes evident, suggesting that the market's rally is well grounded. It is especially well grounded, if the recovery becomes well entrenched and becomes a solid expansion, as we expect. That will take longer to become evident. Still, profits appear to be right on track.
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