The recent rally in equity markets has been quite impressive. The Nasdaq had a run of twelve straight days in the black, which will in all likelihood come to an end Friday as Microsoft (NASDAQ:MSFT) is down big after disappointing earnings. This is the longest streak of positive days in the Nasdaq dating back to 1992, and so much of the bullishness can be attributed to a second straight quarter of better than expected corporate earnings results. While we are not complaining that the Dow has reached the 9000 level again, there are real concerns about the foundation of this rally; the enthusiasm spurred by “better than expected” yet still weak earnings. The theme of this earnings season has been cost savings, which help corporate earnings rebound from bad sales results.
“What’s pushing the stock market upward? Mainly, unexpectedly positive second-quarter corporate profits. But those profits aren’t being powered by consumers who have suddenly found themselves with a lot more money in their pockets. The profits are coming from dramatic cost-cutting — including, most notably, payroll cuts. If a firm cuts its costs enough, it can show a profit even if its sales are still in the basement.
The problem here is twofold. First, such profits can’t be maintained. There’s a limit to how much can be cut without a business eventually disappearing — becoming, in effect, a balance sheet in space. Secondly, when businesses slash payrolls to show profits, consumers end up with even less money in their pockets to buy the things businesses produce. Even if they hold on to their jobs, they’re likely to fear that they won’t have the jobs for long, which causes them to retreat even further from the malls…Operating income for companies in the S&P 500 that have reported so far has been almost 29 percent lower than last year, more than 80 percent lower than 2007, according to Standard and Poors. Ouch…
Keep your eye on the real economy, where unemployment and underemployment keep rising. It’s not as much fun as cheering and investing right now, but it’s far safer.”–Robert Reich
The market has grabbed a hold of this “better than expected” sentiment with gusto, and the economy does seem to be headed towards growth rather than the meltdown we faced just nine months ago. However, we are still treading very carefully in this newly overbought market. The market is not attractive from a valuation standpoint, nor do we believe that the economy has worked through all of the potential stumbling blocks. The housing market has stabilized, but we have observed commercial real estate showing signs of significant strain. Consumption is the largest driver of economic growth, and with unemployment rising and consumer credit shrinking we don’t see that improving before 2010. Once this bubbly sentiment wears down and we realize that growth in an environment of double digit unemployment may be slower than hoped, the market could be vulnerable to a reversal.