Market steps higher on strong earnings

Early in the year, I doubted whether companies would meet what seemed like optimistic expectations by Wall Street analysts. As the mid-year earnings season draws to a close, however, it became apparent to the market, and to me, that U.S. companies have adjusted well to the “new normal.” Profits have rebounded, and in some sectors are well above previous peak year levels.

The healthcare and consumer staples sectors are reporting earnings that are more than 30 percent above 2006/2007 earnings levels. Technology earnings are also at record highs. Overall, earnings on the S&P 500 Index companies are nearly $20, hitting their stride and making the beginning of the year estimates of $75 look very reasonable, if not a layup. My cautious outlook has turned out to be too conservative. Given the nearly 10 percent increase in the level of the index since companies began reporting earnings, apparently I was not the only investor who had been skeptical of whether companies could hit their earnings targets.

Given the current level of earnings, the market valuation seems to be very reasonable. Corporate America has laid off workers, refinanced debt at lower rates, controlled inventory levels, and benefited from lower materials costs. What makes this earnings growth even more impressive, along with the overall growth in retail sales and technology revenues and purchasing manager new orders, is that these new heights are being scaled while most commercial banks are keeping small business borrowers at bay and pushing less creditworthy borrowers closer to default by raising loan rates while their own cost of funds is quickly approaching the level of “free.”

It is interesting to see just how strong many of our key economic indicators look, with corporate earnings being the prime example, given the anemic growth in the money supply and general levels of anxiety felt by most business owners. If the bankers would actually let some of this capital they’ve been given escape back into the business sector (even by accident), I imagine that the money supply would surge higher and this economy would be off to the races.

Indeed, the market feels like a coiled spring that wants to go much higher. On bad news, it goes down a little. When good news hits the wires, the market goes up 2 percent in a day. After falling on bad news in the morning, it inches up higher the rest of the afternoon. It feels like it wants to soar, but the economy just can’t quite turn the corner, so the market remains anchored to a domestic economy that has stabilized, in recession.

The good news is that I can easily imagine the start of a new economic recovery just around the corner. It wouldn’t take much. Global freight rates have fallen. Either the global economic boom tanks, or freight rates will turn up. Small business pessimism runs rampant. It can’t go much lower, so in the long run has only one direction to go. It’s just a matter of “when.” When will small business get access to financing? When will business stop feeling like it’s the enemy of the government? When will small business start hiring again and begin to reduce the unemployment problem?

This will certainly be the longest economic bottoming process since the 1930’s. The good news is that, to me, it increasingly looks like we’re putting in a bottom and preparing to trend up. The strong earnings are a sign that the economy is adjusting to the obstacles to recovery that have been put in its path. As the political process continues to move toward removing the obstacles, the outlook for the market is improving. Sometimes markets rally for the wrong reasons. This rally, though, is signalling that our economic patient is returning to health. While not yet fully recovered, there are signs of health that might be overlooked by journalists still focused on the many problems still scattered across the landscape. Celebrate the healing process as it unfolds, one step at a time. 
 
 Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies .

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