Sunday, October 18, 2009

The Quality of Earnings is Not Strain'd? Or Is It?

The quality of mercy is not strain'd,
It droppeth as the gentle rain from heaven
Upon the place beneath. It is twice blest:
It blesseth him that gives and him that takes.
William Shakespeare, The Merchant of Venice, Act 4, Scene 1

As for the quality of earnings, that may be another story.

If the markets are a stage, then Q2 earnings was tragedy, portrayed in the media as epic triumph, seen by many as comic irony or outright farce.

Markets were happy with almost any glimmer of hope, even if it was just beating lowball expectations on one time cost cutting or asset sales.

For Q3, the markets want at least the start of a Hollywood happy ending, ideally with guidance suggesting a Xmas time Q4 ending like It’s a Wonderful Life, just in time to salvage what’s left of retail and commercial lending.

Because stocks and other risk correlated assets sitting on eight months of gains and hopes for growth already priced in, markets want to see actual improvement in the underlying, ongoing businesses. Because one can’t cut costs or sell assets forever, there has been much ado about the need for companies to show improvements in top line revenues, i.e. the amount of money they actually take in.

Last Friday’s sharp decline across the range of risk assets on the back of disappointing earnings from Bank of America (BofA) and lower than expected revenues from multinational industrial bellwether General Electric (GE) could prove to be a significant signal of risk appetite turning to indigestion.

The BofA has long been seen as a relatively weaker link amid the big US financial firms, so the result was not so bad for the sector as a whole considering the much better outcomes from other leaders earlier in the week; meanwhile, the GE report offered few surprises and beat expectations on the actual earnings portion of the report. Overall, it seems the fast, violent selloff that followed may have reflected a market that was looking for an excuse to take profits as recent gains increasingly look overextended.

Equities have jumped to the highest levels since 2003 relative to earnings, which seems more than a little overdone in a year when the world economy is set to see the first contraction in global output since the Second World War.

If bullish momentum has in fact been exhausted, a deep correction lies ahead for risk assets in general, and so very oversold USD and other safe haven assets could move up fast.Expect the opposite to occur not only to stocks, but gold, oil, and especially the oh-so-overbought commodity and high yield currencies and euro

In sum, earnings announcements will need to show improving sales and Q4 guidance in order to prevent “strain’d” rally from going lame.

Disclosure. The author has no positions in the above mentioned stocks or currencies.

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