In a recent post (see Are Better-than-Expected Earnings Illusory?) I suggested that first quarter earnings came in better than expected largely because corporations undertook larger-than-expected cost cuts.

In response to economic malaise, it’s fairly typical for firms to try to reduce costs in an effort to stave off the deleterious consequences of decreased demand. There are several ways that a firm can do so: through layoffs, by rationalizing product lines, by trimming fat from operations, and/or by squeezing suppliers for lower input costs.

Nike provides a classic example of the illusory earnings effect that I described in that post. Take, for example, the following nonsensical headline from CNBC: Nike Posts Surprise Profit Increase, Tops Estimates. At first glance, one might think, “Wow, great news, Nike (a consumer products giant) did well. Maybe there are some green shoots in this economy after all.” But after digging a bit deeper, reality sets in:

The maker of athletic shoes and apparel said after markets closed Wednesday that it earned 99 cents a share in its fiscal fourth quarter, excluding one-time items. Nike reported revenue of $4.71 billion during the period. On a comparable basis a year ago, Nike turned a profit of 98 cents a share on a topline of $5.088 billion.

During the quarter, Nike reduced several layers of management and cut more than 1,750 jobs worldwide, or 5 percent of its global work force. About 500 of the jobs lost were at Nike’s world headquarters in Beaverton, Ore.The cuts come on top of other measures that the company has taken—including a hiring freeze and tight inventory controls—to improve its bottom line as the economic meltdown took a toll on its sales.

So, let’s take stock. Nike’s revenues were down 8% from last year. The reason it reported profits that beat estimates was because of layoffs and its success in squeezing its suppliers.

As I wrote in my previous post:

…cost cutting has systemic implications…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).

Squeezing suppliers generates the same effect. It reverberates up the supply chain by reducing supplier revenues leading to fewer jobs leading to reduced consumer spending which then reduces demand for firms’ products resulting in decreased corporate profits leading to fewer jobs. Again, wash, rinse, repeat.

I concluded that post by suggesting:

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.

I concede that the economy is more stable now versus when Lehman collapsed and AIG nearly collapsed. We successfully averted the financial armageddon scenario. However, I believe that economic growth and corporate earnings are farther off than most think. Nike is fairly representative of the broad corporate earnings effect that I described in that prior post, and writ large, anemic corporate earnings coupled with cost cutting are likely to keep economic growth muted for quite some time.

So I ask: Where are those green shoots?

I am officially confused.

Much has been written about how managers respond rationally to pay incentives, and how their supposedly “rational” behavior manifests as excessive risk taking with other people’s money. Many have even detailed how excessive risk taking brought about by distorted pay incentives was central to the financial crisis.

I agree that excessive risk taking played a role in the financial crisis. This has been well documented. Moreover, I am willing to concede that in some cases the behavior observed may have seemed rational. At the very least, the managerial behavior was a response to some form of incentive. And after all, we know incentives work, …even distorted ones.

Indeed, I have even written a bit about executive compensation and managerial excess on this blog (see Op Ed on Executive Pay, The Credit Crunch and Executive Pay, New Approach to Executive Compensation, and Revisiting Executive Pay). But for me, the issue of executive pay is a systemic, economy-wide problem, not simply limited to the financial sector.

That said, there is one thing that has always bothered me about the explanation that somehow managers acted rationally, and that this “rational” behavior to an existing incentive structure caused the financial crisis. That is, it implies that someone else, somewhere, acted irrationally.

For example, Calculated Risk, discussing Martin Wolf’s column (see Financial Reform and Incentives or Reform of Regulation), writes:

[Martin] Wolf discusses how it is rational for management…to gamble when the risks are asymmetrical (huge potential winnings, limited losses).

But this begs the question: Why was a system that provides managers the incentive to make stupid bets like that constructed in the first place? That seems pretty irrational to me.

If the person/people who built such a system were rational, they would have anticipated the deleterious consequences of the system that they were about to enact, and they would have refrained from so doing.

So then who are all these irrational people running around building silly executive compensation systems? Aren’t they, after all, current and former managers – boards of directors, compensation consultants, and the like?

So then remind me again, how can managers be the rational ones??

I appeared on the Cavuto show on Fox Business News last night (see Appearance on Cavuto for specifics). We talked, in general terms, about Fiat and Chrysler.

The segment ran for a total of about 4 minutes. There’s not much meaningful information you can share in that amount of time, but I tried my best. Unfortunately, we only got to talk about one aspect of the deal – the integration. I would have welcomed the opportunity to share my views on the specifics of the integration in greater detail. I would have also liked to have touched upon Fiat’s product portfolio and whether their products will inspire the American consumer, especially in a market that is already saturated. But we never got there.

Although I don’t necessarily agree with Cavuto’s politics, on a personal level I thought he was very gracious, charming, and funny even. During the commercial break we discussed some of the ills confronting the global auto industry – i.e., the severe overcapacity problem (in the order of 20-30 million units per year). We also talked about the prospects of Chrysler ending up right back in bankruptcy within 5 years. That is a distinct possibility.

I have been trying to find the video link to post it, but I have not had any success thus far. I will definitely post it when/if I do find it.

I was able to find a transcript of the interview. The transcript (with some minor edits for clarity) appears below.

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CAVUTO: Well, Robert Salomon thinks that Fiat may be nuts. He says that it is a stretch to imagine the Italian automaker could bring Chrysler back to life. And here, Robert, he’s a very thin, fit guy, he could fit in those Fiat cars, it’s certainly not that as an issue. Why don’t you think this works?

SALOMON: Well, prima facie, if you look at the deal it actually seems to make some strategic sense. On the one hand you have Fiat whose strengths lie in the small cars, engine technology, fuel-efficient automobiles and Chrysler whose strengths lie in minivans and Jeeps. So, you put that combination together, the product portfolio looks pretty nice. Also geographically…

CAVUTO: But there may have been others who where that (INAUDIBLE, but I think he said something to the effect that there were other suitors who shared such complementarities with Chrysler) like Fiat who could have similarly seen such a merger and they did not.

SALOMON: That was the proposition behind the entire Daimler Chrysler deal to begin with. It was Daimler has the high end saloons and Chrysler had the smaller sort of mass-market brand and that combination then would create strategic overlap. So, you could look at this deal and say there’s some strategic overlap and even geographical [overlap], you have Chrysler’s strength in the United States [and Fiat's in Europe].

MY SIDEBAR: Although I said, “overlap”, I meant, “complementarity.”

CAVUTO: [But why don’t] you think it’s going to work, if it makes sense on paper?

SALOMON: I think when the rubber hits the road you need to think about the integration and integrating these two firms; and I think Fiat, at this point, is getting itself in over its head, especially in taking on Chrysler.

CAVUTO: One other issue, I always look at if it was so attractive a lot of people would be bidding for it. Have you ever been to school where you look back and see the most hideous, horrendous troll of a person in your class got married, right? In my case, that was me. Everyone said, gee, Neil got married, what the hell? And so I am saying that there is a socket for every wrench, you know? But I am wondering if there were any other interest sockets for the wrench they would have popped up. Fiat kept being the only one. We’re interested. We’re interested. It’s sort of like a, you know, “Shrek” with the queen, deal. You know? Like, oh well, that’s it. You know?

SALOMON: Yeah, and you know, I would not characterize Fiat as the most sound automobile maker in the world right now, either. Fiat has had its share of trouble. You go back five years and Fiat was on the brink of bankruptcy.

CAVUTO: Right, they’re hardly a management test case, here.

SALOMON: Right, so if you look at — and that, actually, though, is Sergio Marchionne’s argument which is, “Hey, we have been here, we’ve been through bankruptcy. We know what it means…”

MY SIDEBAR: I was in the process of saying, “to turnaround a troubled automaker“ when he cut me off.

CAVUTO: We know how to screw up. We’re experienced at screwing up. That’s a hell of a way to market yourself. How do think (INAUDIBLE), if they get back some of the initial marketing and integration hurdles you talk about, which they never really quite did with Daimler. Then what? On paper, like you say, it does make sense small and large, these oil prices keep rising up as they seem to as of late, there could be something to this, but even then the Fiat cars are delayed getting here, quite some time, right?

SALOMON: Yeah, I mean it takes five to 10 years for Fiat and Chrysler to work as a unified organization.

MY SIDEBAR: I did not mean to imply that it would be five years before Fiat cars start arriving on the U.S. shores (they will begin selling here relatively quickly – within 1-2 years), only that the integration process will take that long.

CAVUTO: Really, that long?

SALOMON: Yeah, I think so. I mean, you’re looking at five years for this integration. The integration, again, it’s hard enough to do a domestic integration, but to do this now on a global scale where you have cultural problems, language problems, institutional problems across these two countries that makes it very, very difficult to manage.

CAVUTO: So, you think Steve Rattner, the auto czar, whoever is spearheading this process, was just pushing this because it was the only deal in town?

SALOMON: That may be right. The alternative, right, was liquidation and was the wholesale liquidation of Chrysler. And I think the question there became, “Are we willing to live with the consequences of that outcome?”

CAVUTO: Very good stuff. Robert, thank you.

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I will be appearing on the Cavuto show on Fox Business News tonight at 6pm to discuss the Fiat/Chrysler alliance. My understanding is that the purpose is to discuss the strategic implications of the alliance – does the Fiat/Chrysler combination make sense, is Marchionne well-suited to run the combined firm, will the alliance succeed…

You can find my some of my views on the strategic combination of Fiat/Chrysler in the following posts:

• Can Fiat Really Pull it Off
• Is Fiat Nuts
• Now Introducing Fiat/Chrysler
• Chrysler and Fiat Revisited
• Fiasco for Fiat

I will post the video after tonight’s show.

The Supreme Court delayed Chrysler’s reemergence from bankruptcy yesterday by issuing a stay (see Court Adds Uncertainty to Chrysler Reorganization). According to the Associated Press:

Chrysler’s five weeks of breakneck-speed bankruptcy proceedings came to a screeching — but possibly temporary — halt Monday, when a Supreme Court justice delayed its sale of assets to Italy’s Fiat.

The move could derail the government’s ambitious plan for the U.S. automaker to blaze a path to profitability without the burden of many of its debts.

Justice Ruth Bader Ginsburg issued a stay…

This is a story that I have been following for some time (see Legal Issues Affecting Chrysler, Anything but Surgical or Lessons for GM for background). Back then I discussed the group of Non-TARP lenders who were opposed to the deal. Their claim was that the sale to Fiat neither respected their rights as senior creditors nor made them whole. Unfortunately, their opposition quickly faded, as it became clear to them that they were not only swimming upstream, but that the cost of opposition was more than they were willing to tolerate.

Although the group of dissident lenders disbanded, a group of Indiana pension and construction funds continued the fight. As explained by the AP:

…the Indiana funds, represented by the same law firm as the dissident debtholders, filed their own objection and eventually appealed to the 2nd U.S. Circuit Court of Appeals and the Supreme Court. They claim the sale unfairly favors Chrysler’s unsecured stakeholders such as the union ahead of secured debtholders like themselves.

The funds also are challenging the constitutionality of the Treasury Department’s use of money from the Troubled Asset Relief Program to supply Chrysler’s bankruptcy protection financing. They say the government did so without congressional authority.

The funds hold about $42.5 million, or less than 1 percent, of Chrysler’s $6.9 billion in secured debt. They bought it in July 2008 for 43 cents on the dollar.

The Indiana funds are not likely to prevail. As was the case with the group of dissident lenders, the Indiana funds are in the minority among their own class of creditors (the total group of first lien holders including the likes of Citigroup and JP Morgan). They also hold less than 1% of the total debt.

That notwithstanding, they still do have a point, and are raising valid concerns. The issues they raise not only go to the root of creditor rights, but more importantly, raise fundamental questions about the rule of law. And to borrow from William J. Bernstein, “A law that does not apply equally to all citizens, the ruler included, is no law at all.”

So good for the Indiana pension and construction funds (and their legal representatives) who, despite the odds, fight not only for their own rights, but also for the rights of all citizens in a vibrant democracy.

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UPDATE: 6/9/2009 at 9pm

Actually, yes so fast. Nearly 24 hours after Supreme Court Justice Ginsberg issued her stay, the Supreme Court vacated the stay effectively clearing the sale to Fiat (see Court Clears Chrysler Sale). According to the SCOTUS blog:

Justice Ginsburg set off a wave of speculation, some of it well wide of the mark, by issuing a brief order Monday afternoon temporarily staying the transaction.  Suggestions in several quarters that her delay might have meant that the Court was signaling that it might hear the challengers’ case and decide it proved to be entirely without foundation.

MY COMMENT: That’s a bummer. I still believe that the challengers (in particular, the Indiana funds) had a point, especially with respect to the issue of constitutionality. And, in fact, even in its statement, the Supreme Court recognized that:

a denial of a stay is not a decision on the merits of the underlying legal issues.

To summarize the SCOTUS post:

First, the three delay requests filed by three Indiana teacher, police and construction worker benefit plans (08A1096), by a variety of consumers groups (08A1099), and by Patricia Pascale, a widow suing for her husband’s asbestos-related death (08A1100), were denied, and Ginsburg’s temporary order was lifted.

Second, stressing that it was not ruling on the merits of these challenges, the Court listed the factors that govern whether a stay, or delay, would be granted.   Among those are whether four Justices would agree to hear the case on the merits, whether there was “a fair prospect” the Court would overturn the lower court ruling (here, a decision of a bankruptcy judge in New York), and whether “irreparable harm” would result if no stay were granted.  This paragraph added that, “in a close case,” the opposing rights and needs of each side would be balanced against each other.

Third, the Court stressed that no one had a right to a delay, since that was a matter of “judicial discretion.” It added that the party seeking the stay had the burden of justifying it, and concluded: “The applicants have not carried that burden.”

Finally, it stressed that the matter was one to be examined on the basis of a particular case, requiring “individualized judgments in each case.” It closed with this: “Our assessment of the stay factors here is based on the record and proceedings in this case alone.”

Although I thought that it was an absolute long shot that the high court would overturn the decision coming out of the lower court, I never expected a decision to come this quickly.

But there you have it. Hello Fiat-Chrysler.

No real news on GM today. The market largely anticipated the event, as it had been wholly telegraphed by the Obama administration (see Finally a Sensible Approach).

Moreover, as I stated on several occasions, if handled properly, there would be no reason to fear a GM bankruptcy (see Could GM Survive Bankruptcy?). Back then I concluded:

YES, GM could survive bankruptcy, and we needn’t be frightened by the prospects, …no matter how much GM tries to convince us that it would spell the apocalypse.

So here we are post bankruptcy, and as far as I can tell, the world has neither come to an end nor has the economy ground to a halt.

In a broader sense, the market’s lack of response to GM’s bankruptcy sends a signal that the economic future of the United States is no longer dependent on, or inextricably tied to, firms like GM. This is not to say that manufacturing is not important to the prosperity of the United States; rather, simply that the manufacturing future of the U.S. is not about the manufacture/assembly of automobiles. But that’s another story for a different day.

For now then, I’ll simply share GM’s official bankruptcy press release. It was sent to me from our new employees – the kind folks from the new GM, the firm in which you, me, and the rest of the American taxpayers will become majority shareholders. Click below to view the full release.

GM Bankruptcy Press Release

Now back to the fascinating part of the bankruptcy – the impending battle between GM bondholders and the U.S. Government. I would not be surprised to see this battle play out in much the same fashion as the battle between creditors and the U.S. Government in the Chrysler case (see Chrysler Bankruptcy: Anything but Surgical, Legal Issues Affecting Chrysler, and Lessons for GM for background). Nevertheless, as I suggested in my post Lessons for GM:

Although the debt restructuring problems they both face are the same in theory, in the case of Chrysler, it was much easier for the federal government to get Chrysler’s lenders to accept a haircut because the majority of its first lien debt sat with banks that accepted TARP money (e.g., Citigroup and JP Morgan). The government could therefore exert tremendous influence over these lenders.

Not so in the case of GM. GM’s bondholders are a much more diffuse bunch with disparate interests. Moreover, the government has much less of a direct influence over GM’s bondholders.

Although GM was able to reach an agreement, in principle, with many bondholders (see US Strikes Deal with Bondholders), it will be interesting to watch how those who remain opposed to the deal ultimately play their hand.

For those of you who have followed this blog, you know that I have been very critical of Tata’s acquisition of Jaguar and Land Rover (see Buyer’s Remorse and Tata and Jaguar/Rover Update). As I suggested when the deal was announced:

I think that this deal is destined to fail.

…For Tata, while bold, the deal just doesn’t make much sense. Aside from several luxury brands, an increased global presence, and some notoriety, I’m not sure what Tata gains. For example:

1. Where’s the synergy? Can Tata and Jaguar/LR share components, design, production, dealerships, or management? On its face, the synergies are just not there. But perhaps the investment was made for learning purposes, with Tata hoping to use Jaguar/LR capabilities to improve the quality and/or image of their existing automobiles. Possibly.
2. Can Tata rationalize Jaguar/LR’s production to make them more profitable? Actually, they cannot. They made pledges not to cut staff or close plants. And it’s unlikely that they would be able to reduce costs substantially by sourcing parts and supplies from India.
3. Can Tata right a ship that larger, more experienced, more formidable competitors had been unable to? In Jaguar and Land Rover, Tata is inheriting pieces of the old British Leyland Motors (Jaguar, Rover, Austin, Morris, etc.) that all tolled experienced (and continues to experience) more than 40 years of uncompetitiveness and underperformance. Quite simply, they are inheriting a lot of baggage (see Riding the Elephant for more background on British Leyland). It will be difficult for Tata to overcome this tremendous inertia.

Some analysts have argued that Jaguar and Land Rover were purchased on the cheap (at $2.3B minus $600M that Ford is throwing in to offset pension liabilities), and at the right time – when both Jaguar and Land Rover have a stable of new models about to hit the market (e.g., the Jaguar XF and the Land Rover LRX). These analysts point out that if these new models hit it big, it will make Tata’s acquisition look like a steal. However, this assumes that Tata can revive flagging sales at Jaguar and Land Rover in the middle of a downturn. Likewise, it assumes that Tata, by simply owning the brands, will not dilute their image. Finally, it assumes that the Jaguar and/or Land Rover brands can be revived after years of neglect and consumer dissatisfaction, and that consumers will once again be interested in buying relatively expensive, gas-guzzling cars and SUV’s (especially in the case of LR).

I remain skeptical.

When it became clear later in the year that demand had collapsed in the auto industry I wrote:

And it looks like things will be even tougher [for JLR and Tata] with global demand…slowing quite a bit.

I was therefore not surprised to see an article in this week’s Economist detailing some of the difficulty that Tata has been experiencing with its Jaguar/Rover subsidiary (see Indian Firms’ Foreign Purchases). Although the purpose of the piece was to review (broadly) the history of Indian overseas investment, it provided some perspective into Tata and JLR.

…several of corporate India’s acquisitions now seem ill-advised. The purchase of Jaguar Land Rover (JLR) in 2008, for example, saddled Tata Motors with a prestigious brand, prodigious losses and a $3 billion loan, the last $1 billion of which it managed to refinance on May 27th, days before it fell due. It has had to call on the help of the Tata Group’s holding company, which underwrote its faltering rights issue last year, and the indulgence of India’s biggest state bank, which guaranteed an $840m bond it floated in May. In a recent interview, Ratan Tata, the group’s chairman, admitted that the company bought JLR at an “inopportune time”.

The authors then pose the following questions:

So were these acquisitions fundamentally sound decisions cursed by poor timing?

MY COMMENT: Naw, that doesn’t sound right.

Or were they bad decisions flattered by easy money?

MY COMMENT: Ding, Ding, Ding, Ding – we have a winner.

As we wait for GM to officially declare bankruptcy (see Bondholders Push GM to Brink) and a decision on Opel (Berlin Considers Buyer for GM Unit), I thought I’d share an interesting article from this week’s edition of the Economist on Fiat’s quest to create a global automobile firm (see Marriages Made in Hell).

According to the Economist:

The bold attempt by Sergio Marchionne, chief executive of the Fiat Group, to use the crisis that has overwhelmed Detroit to forge a three-way merger between Fiat Auto, Chrysler and General Motors’ European arm, Opel, has been greeted both with admiration (for his chutzpah) and scepticism (about his ability to pull it off). The sceptics say cross-border mergers in the car industry have a poor record and that Mr Marchionne is biting off much more than he can chew.

Assuming Mr Marchionne does get both [Chrysler and Opel] deals done, that is when the hard part will begin. Adam Jonas of Morgan Stanley says that although the three-way combination could make 6m cars and around $100 billion of revenue, he doubts whether it will be able to operate in a fully integrated way like VW or Toyota “for perhaps decades”. He also questions Mr Marchionne’s faith in scale, suggesting it is a function of success rather than prerequisite for it and gives warning that even successful mergers bring with them “many hidden cost burdens (financial and non-financial)” and that these can spiral if things do not go well.

The doubts are rooted in experience. With the partial exception of the alliance formed between Renault and Nissan a decade ago, auto-industry mergers usually go wrong and destroy rather than create value.

Personally, I think it is extremely generous to refer to the Renault and Nissan deal as a success. Let’s just say it hasn’t fallen apart, yet. But that is neither here nor there. The real point is that these types of deals generally fail.

The skepticism detailed in the Economist is entirely consistent with the views I expressed several weeks ago in the post Is Fiat Nuts??:

If it weren’t enough that Fiat is trying to expand on the North American front via its alliance with Chrysler (see Now Introducing Fiat/Chrysler), it now seems as if Fiat wants to simultaneously expand its empire closer to home (via an acquisition of Opel)…

Are they nuts??? It is hard enough to pull off one integration the size of Chrysler, but now they are going to try to pull off two? And to top it all off, we’re talking about foreign integrations, where economic, political, and cultural differences compound the complexity. Frankly, I am surprised that Fiat’s board would give Marchionne the approval to simultaneously attempt both deals. A prudent board would counsel Marchionne to eat one cookie at a time, lest he get indigestion. So much for corporate governance.

“From an engineering and industrial point of view, this is a marriage made in heaven,” [Marchionne] was quoted as telling the Financial Times on Monday.

Or [as I put it at the time] an integration made in hell.

The Economist continues:

The corporate troubleshooter [Marchionne], who, since 2004, has been responsible for a highly successful turnaround at Fiat, has reached the conclusion that volume carmakers will in future need to sell at least 5.5m vehicles a year to be viable. With just over 2m sales last year, Fiat is too small to get there on its own. The choice, he believes, is a stark one: Fiat must be either a nimble hunter or wait to be gobbled up by someone else.

I responded to that specious logic with the following:

I just don’t get it. Why the preoccupation with size? I remain unconvinced that largess is a means to success. Just ask Jurgen Schrempp and the folks at Daimler, who ran around spewing the same nonsense about scale and survival before their acquisition of Chrysler.

Size certainly leads to increased revenues, which helps justify exorbitant managerial pay. But given the organizational complexities that go hand in hand with size, size does not always translate into increased profitability.

In order to truly benefit from size, there must exist extremely large economies of scale and scope. Perhaps such economies (the ability to economize on platforms, dealerships, suppliers, etc.) exist in theory in the auto industry. However, the power of the auto unions, coupled with the structural characteristics of the countries in which Fiat, Chrysler, and Opel operate make capturing synergies very difficult.

Fiat will certainly encounter difficulties when trying to capture synergies based upon economies of scale. But the trouble with Marchionne’s logic does not end there.

The fact remains, there is absolutely nothing wrong (from a strategic perspective) with being the hunted instead of the hunter. Lest we forget, managers act in the capacity of agents for shareholders. As such, they have a fiduciary responsibility to maximize shareholder value. If maximizing shareholder value means selling to a high bidder, then so be it. Shareholders generally end up better off in cases where their firm is the target rather than the acquiror. Moreover, looking only to be the hunter can be self-serving on the part of managers – it helps enrich them, allowing them to build empires and become entrenched along the way, while ultimately destroying shareholder value.

If Marchionne is truly interested in acquiring Chrysler and Opel because he believes it is better to be the hunter than the hunted, then we must question his motivation. It could be, as I pointed out in my previous post (Is Fiat Nuts??), that:

Marchionne, aided by a board of directors that he has in his back pocket, is engaging in a form of empire building whereby his own personal interests in building the world’s second largest automaker are taking precedence over the best interests of Fiat’s long-term health and prosperity.

Nevertheless, for those of you interested, I encourage you to read the entire Economist piece. It provides a nice perspective on the proposed three-way deal. That said however, it still came across as if the authors believe that the Fiat/Chrysler/Opel deal makes strategic sense, and that if anyone could pull off such a deal, it is Mr. Marchionne.

I am less sanguine. My stance toward Fiat/Chrysler/Opel therefore remains: Guilty until proven innocent.

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…

I’ve been tied up with end of year meetings, graduation, and conference travel lately. This has kept me from posting as regularly as I might like. But I did get to see Hillary Clinton speak at NYU’s commencement last week (see Clinton Gives NYU Commencement Speech).

I quite liked Hillary’s speech, but then again, I’m a sucker for idealistic, inspirational graduation messages. Between you and me, I also enjoy the pomp and circumstance, and the pageantry of the day. And as much as we academics like to complain that graduation ceremonies are long, boring, and suck up otherwise productive hours from a day, a good speaker or two can go a long way toward making the experience worthwhile.

A good set of commencement speeches never fail to remind me why I got into the education business in the first place – to learn, to discover, to share, to teach, and to inspire. Needless to say, I came away from the NYU commencement ceremony feeling reinvigorated and reassured about our academic mission (despite the economic challenges).

So now that I’ve had all the inspiration I can take for one week, let’s switch gears to something not quite as uplifting – the impending bankruptcy of GM (see GM Doesn’t See Deal Before Deadline). According to the NY Times:

With a week remaining before the expiration of a tender offer to its bondholders, General Motors said Tuesday that it did not expect to reach an agreement with the United Automobile Workers and others before bondholders decide.

G.M. is trying to persuade the holders of $27 billion in unsecured notes to exchange them for about 41 cents on the dollar. It must receive tenders for 90 percent of its bonds in order for the offer to be successful and avoid a bankruptcy filing.

Many analysts believe that the offer, which expires May 26, will fail and that G.M. will seek Chapter 11 protection.

But we knew that already.

And we wait…