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You Ain't Seen Nothing Yet

11/02/2009 12:07 pm EST


James Stack

President, Stack Financial Management

James Stack, editor of InvesTech Research, warns against underestimating corporate earnings and the current bull market.

Without a strong double-digit gain in the closing two months of the year, this decade is destined to soon become the worst in Wall Street history. Even the 1930s—which encompassed the Great Depression years—managed to end with a milder loss.

No wonder investors are disillusioned. Yet many have run to cash, or are turning to bonds at what might be one of the worst times in history for income investments. If today’s record deficits and uncontrolled government spending triggers higher inflation in the years ahead, then long-term bonds are the last place you’ll want to be...

Facts are facts. And while many are focusing on the deficit, debt and ongoing banking woes, there is very compelling evidence that this recession is now history.

Consumer expectations, measured by the Conference Board, have risen dramatically since the first quarter of this year, and are now nearing 21-month highs.

Meanwhile, the “Future Expectations” minus “Present Situation” graphic is sending a textbook “end of recession” message.

CEO confidence is following suit. The employment outlook is [also] improving. Forget about the monthly unemployment rate, which can continue climbing for many months after the end of a recession (over a year after the last two recessions). The initial claims for unemployment continue to fall—confirming that layoffs are slowing, and the end of the recession is likely behind us.

The economic rebound might be stronger than we think. The majority of debate seems to be whether the painfully slow recovery will continue, or if we’ll see a “W-shape” with another drop back into recession. Few are asking whether the next six to 12 months might be stronger than expected. While not making that forecast, we’re at least asking the question. One reason is that the rebound in manufacturing (ISM Survey of Purchasing Managers) has been surprisingly strong.

And the ISM New Orders Index has been even more pronounced. The government’s own Leading Economic Index has now risen for six consecutive months—again in classic end-of-recession fashion.

The Naked Truth About Earnings…
Most seasoned investors will readily agree that the stock market leads the economy. And yet they somehow jump to the opposite conclusion that corporate earnings should lead stock prices. That has seldom been the case—especially coming out of recession. In fact there is an average eight-month lag between the end of the recession and when investors start seeing a positive earnings increase.

Why such a lag? One reason is that any astute corporation will use a recession as an opportunity to increase efficiency (i.e., profit margins) and clean up their balance sheet. Unprofitable segments or divisions are shut down. Depreciable assets or amortization will be written off as an expense. The impact on earnings is negative, but it significantly improves the potential profitability coming out of the recession. And with this recent recession being the longest in 76 years, it’s normal to expect a lot of restructuring to have a major impact on corporate earnings.

Frankly, outside of the banking debacle and boom-to-bust cycle in commodities, we’re fairly impressed with the stability in corporate earnings. In fact, some sectors (Consumer Staples, Health Care, and Utilities) are seeing healthy increases from what were previously “peak earnings” in the second quarter of 2007. Technology and Telecom are down only slightly, while Consumer Discretionary and Industrials are off about what might be expected from a severe recession. In other words, if you look past the boom-to-bust commodity cycle and the financial debacle, then corporate earnings are not as scary as they seem.

And if you look at the alternative of sitting in cash (a money market fund or T-bills), then stocks look pretty attractive by comparison.

So when looking at valuation arguments from Wall Street pundits or in the media headlines, always remember:

  • Earnings never tell us where the stock market is headed… instead, the stock market tells us where earnings will be a year from now.
  • Measuring valuation is not black and white… there’s always a lot of “gray” involved.
  • In many cases—especially after a recession—all the hype about earnings and valuations is simply “noise”… the kind of distracting information that keeps you from focusing on what’s important.

It’s important to understand that if this bull market is for real (as we believe it is), then it could still be in its early stages. Yes, there are lots of obvious problems and dark clouds overhead, yet that is usually the case in the first year of a new bull market. The first 6 to 12 months of a new bull market are always the most disbelieved and unloved.

Our good friends at the Economic Cycle Research Institute (ECRI) just had this to say in their October US Cyclical Outlook:
“…the current performance of ECRI’s leading indexes—not only their strength but also their unanimity—indicates that the early stage of the current recovery will be stronger than any since the early 1980s, and will certainly prove to be less fragile than many expect.”

No guarantees, of course, but that’s comfortable company to have on our side.

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