Now more than an ever an upside surprise is needed.
Higher-than-expected earnings are always good news for the stocks market. But as third-quarter reports start rolling in the weeks ahead, another upside surprise would be extremely timely in the fall of ’07. Anything less may spell trouble above and beyond the usual risks.
Optimism has clearly been the dominant force of late. Despite the various financial blows that frightened investors in August and convinced the Fed to cut interest rates by 50 basis points two weeks ago, the stock market has more or less survived and even thrived. Equities are either at peaks or within shouting distance of all-time highs, depending on the index. The implication: the future looks rosy.
That’s a bold statement considering the lingering worries thrown off by real estate woes of late. Home sales, to cite one statistic, continue falling. There’s also the question of whether the labor market is set to contract, as suggested by the August employment report, which posted the first net loss in four years. Recession, in short, has been on the minds of many these past few weeks. But judging by the stock market, such worries are merely the stuff of overactive imaginations.
In fact, let’s not minimize the message emanating from Wall Street. The future looks damn good, equity traders are collectively shouting. “Equity investors clearly don’t see a significant risk of recession or a major slowing in corporate earnings,” Sal Guatieri, senior economist at BMO Nesbitt Burns, told The Globe and Mail on Monday.

If you don’t like that reasoning for why stocks are still rising, there’s an alternative view making the rounds. The prospect of higher interest rates is powering higher stock prices. An intriguing theory, but one that may look paper thin when viewed in context with the longer term. The Fed cut rates because it perceives the odds have risen for an economic slowdown, if not worse. If that’s good for stocks, how does one explain the past few years, when the Fed raised interest rates in the face of a strengthening economy? Anything’s possible, but the idea that stocks are set to rise in economic cycles of growth and decline doesn’t sound convincing. At some point, stocks have to fall, or least stop rising. The operative question: under what conditions might that occur?
Of course, if the view is that earnings will still grow, well, at least the conceptual framework on that one is sound. In turn, that leaves the actual earnings for Q3, along with the question: Is another season of earnings reports poised to impress?
Looking backward, Q2 reminds that positive surprises can still happen in ’07. As Zacks.com noted on Monday, positive surprises dominated disappointments by a ratio of 3.5:1. In other words, Q2’s median surprise was “a very healthy 3.45%,” according to Zacks. “The median growth rate was far higher than was expected as we entered the earning season, coming in at 13.5% [for Q2].”
For some time now it’s been easy to assume that the natural order of the universe is for relatively high earnings growth. Again quoting Zacks: “The second quarter was the 20th quarter, a.k.a. five years, of consecutive double-digit growth in median year-over-year EPS growth for S&P 500 firms.”
Could it roll on? Perhaps, but the hour’s late. Nonetheless, the crowd doesn’t see it that way. The current median outlook for Q3 year-over-year earnings growth for the S&P 500 is 9.0%, Zacks reported. That’s just under the double-digit wire but respectable just the same.
Slower, yes, but hardly the end of the world. Adding to the confidence of lower-but-still-strong earnings growth is the argument that a fair chunk of U.S. corporate earnings come from overseas operations. That, in effect, is a hedge on the risk that the U.S. economy stumbles.
Nonetheless, some trouble makers are starting to use the phrase “sucker’s rally” to describe the action of late. And today, Wall Street Journal columnist Jonathan Clements warns: “Corporate profits are in danger — even if we don’t get a recession.” One reason is that corporate profits have been on a roll for some time, rising at much faster pace than the economy’s overall growth rate. That, Clements reminds, can’t last forever. Neither can the foreign-earnings boost continue to surge higher indefinitely. That’s always true, of course, but the notion of limits carries more import at particular moments of time vs. another. Let’s just say that October 2007 is January 2003 when it comes to looking at forward earnings expectations.
Then again, it’s time to dispatch our standard boilerplate and repeat that no one knows what’s coming, least of all us. Maybe earnings growth will continue surprising on the upside for longer than one might reasonably expect. Your editor, for one, has been humbled for some time as to the power of the major asset classes to continue rising. All of which underscores the point that there are risks to being defensive too soon as well as cautious too late. Each and every investor has to make that decision.
Meantime, one might ask: If now’s not a good time to cut back on equities, particularly U.S. equities, when might such a moment come? Call us crazy, but selling high and buying low is still the only game in town. Beyond that generalized view of money management, the devil remains firmly entrenched in the details.