The Truth about Earnings

From Reader Rob over at pragcap.com:

“Overall earnings still remain depressed even after a large amount of cost cutting which has increased unemployment to 9.5% and U6 unemployment to 16.5% none of which includes employees on furlow several days each month without pay.

The sales figures are misleading. Sales are down 15.6% in Q2 versus being down only 12% in Q1. For Q2 if you take energy companies out of the mix, then sales are down 10% versus prior year and if you also back out materials sales are down 8% versus PY). For Q1, without energy and materials sales were only down -6% versus PY.

That means that in Q2, excluding the effect of commodities, sales are down -8% versus PY, wheras in Q1 they were only down -6% in Q1. There is a seasonal effect on sales so in someways a same quarter prior year comparison in necessary. Ex energy and materials, there appears to be continued deterioration.

If we compare Q2 2009 to Q1 2009, aggregate sales are only up up 3% based on the companies reporting so far. If you take out energy, sales are up all of 1.5% and if back out materials, then sales are up all of 1.3%.

Overall considering seasonal factors and excluding the rising price of oil and other commodities, it looks like sales are down or maybe just flat versus Q1.

By sector, industrials were down -9% vs PY in Q1 and are down -15% vs PY in Q2. (Looks like quarter on quarter deterioration.) Consumer discretionary was down -17% in Q1 and is down -18% in Q2. (Slight deterioration). Consumer staples are down -2% in both quarters. Tech seems to have mildly improved, being down -13% in Q1 and -11% in Q2.

Notably utility sales were down -5% in Q1 and are down -12% in Q2. Significant reduction. (Also Q2 versus Q1 2009 is down -16%.) Not sure how much maybe commodity price pass-through. (Electric usage goes hand-in-hand with economic activity. It is used as a check on the GDP numbers coming from places like China wheras statistics are even more manipulated than in the US.)

I completely agree that the year-over-year comparisons are backward looking but they do provide prospective on the magnitude of the decline, as well as the magnitude of growth. The quarter on quarter changes provide a sanity check for how much progress is currently being made. As we saw in the GDP report the primarily thing holding up growth is government spending.

I did forsee the magnitude housing crisis and sold most all of my stock in mid to late 2007. I bought tentitively in March, but I clearly misjudged the extent to which the markets would rally without any sizable correction. (So far I avoided a large loss, but also largely missed a potentially big opportunity.)

My concern is that the markets have overshot the extent of economic progress which will be made this year. World trade has declined dramatically. Will it really spring back or are we now stabilized at a lower level. Large export economies (Japan, Germany) are springing back a bit but from a very depressed level. China’s rebound seems to be more government stimulus than export driven. Rail and port shipments remain at depressed levels and show few signs of rebounding (current July statistics).

What is an investor to do now? How much upside potential versus downside risk in the near-, mid- and long-term? To me it seems that the risks are substantial in both directions. Momentum could drive the S&P 500 up to 1,200 although expectations seem to be for the mid 1000s probably followed by a correction. On the other hand, unexpected deterioration in economic news could potentially trigger a sharp pullback which could feed on itself by investors wanting to lock in recent gains.

The markets seem to be quite manic-depressive. Three weeks ago all talk was of a re-test based on less than great economic news and technical levels, now all talk is of how high we can go based on better than expected earnings and technical levels. (Per Howard Silverblatt the overall the earnings were actually a bit below expectations and only 41% beat estimates, although I have only seen the statistic 70% beat reported.)

I think that effect of mass unemployment has not begun to hit yet and may be very under-appreciated. Certainly a big wave of foreclosed homes will be hitting the market in coming months after delays, modification attempts, large number of vacant homes being held off the market and new unemployment driven foreclosures. Is the potential for unexpected negative news priced into the market? How quick of a recovery is priced into the market at this point? Judging on the progress from Q1 to Q2 we are at stabilization but recovery is yet to be seen.

Might there also be a risk that instead of the expected inventory building upswing that is universally expected we may see a Q3 which is still flat overall. Inventory to sales levels STILL remain very elevated overall.

Q2 was very light on write-offs. Maybe we will see in increase later this year. Last year write-offs were low in both Q1 and Q2 (following large write-offs in Q4 2007, but then increased dramatically into Q3 and the kitchen sink quarter of Q4. (Did Q408 and Q109 really account for all losses that will be seen over the coming quarters?)”