Now that we are largely out of Q1 earnings season, it might be helpful to take stock of the health of the corporate sector. By many accounts, Q1 earnings were better than expected. The better-than-expected earnings has led some to suggest that economic recovery might be right around the corner – you know, “green shoots” and all (see First Quarter Shows Hint of Recovery). A deeper look at those earnings, however, reveals that they are not all that they are cracked up to be.

It is true that many firms reported earnings that were better than analyst expectations. However, this stylized fact is not necessarily indicative of a recovery in corporate earnings, for the following reasons:

1. Analyst expectations were unrealistically low. Many companies hedged when giving guidance, preparing analysts for the absolute worst. Some companies even refused to give guidance, leaving analysts to founder with their projections.
2. Earnings were down 30% or so from a year-ago level, and nearly 90% over the past two years (see S&P Earnings Decline). No sugar coating it. This was a horrible quarter.
3. Corporations were able to report better-than-expected earnings in large part because they engaged in greater-than-expected cost cutting (see Is Cost Cutting Throat Slitting, ht Anuja). Although cost cutting through layoffs and slashing expenditures can increase earnings in the near term, they can be deleterious in the long run. For example, reducing R&D budgets today can result in a compromised product pipeline down the road. Although cutting costs is the natural (and rational) response to economic malaise, the question remains whether companies cut costs by too much. And it’s not just the firm-specific consequences, cost cutting has systemic implications as well. Many analysts are overlooking the higher order effects of layoffs and capital expenditure reductions on the broader economy. This manifests as the dreaded negative feedback loop – fewer jobs leads to reduced consumer spending which then reduces demand for firms’ products resulting in decreased corporate profits leading to fewer jobs (wash, rinse, repeat).

The key then to the future of corporate profitability lies in whether you believe corporate earnings have bottomed out and will now begin to increase from a lower base, or whether you believe that there is still substantial downside risk that increasing unemployment and decreased consumer spending will continue to put a crimp in profitability. Given the nearly 40% rally in equity markets over the past several months, market participants clearly believe the former. I fear that the latter might be more representative.

All this makes me wonder whether the current rally has legs…

This entry was posted on Thursday, May 21st, 2009 at 2:36 pm and is filed under Business Strategy, Corporate Strategy, Economy. You can follow any responses to this entry through the RSS 2.0 feed. You can skip to the end and leave a response. Pinging is currently not allowed.