One thing has been true of most the major Q3 earnings outside of the banking industry in Europe and the US so far. Revenues have fallen whilst profitability has been underpinned by cost cutting and restructuring. To an extent this story has been one of the factors behind the +50 percent jump in the Dow to past the 10,000 level since the March lows. Over the next 3-6 months it will become clear to investors that profitability growth underpinned by cost cutting is not sustainable. In the short term equities though are likely to be driven by a very different factor, the search for return or the so called, wall of money.
This earnings season is very important. We all go through the numbers looking for clues on where we go from here and how individual company performance will impact the wider market and economy. With bond yields at historic lows as the world's central banks pump trillions into the system, the huge amount of cash held by institutions across the world has to get out of the bond market if it wants a return.
As a result money is pouring back into equities and other assets like gold for want of a better place to go. Pension funds have liabilities that must be met, mutual funds are sold based on a return for the investor and sitting in cash, whilst safe, is not an option for many money managers. This trend will continue until, at some point in 2010 it becomes clear that the Fed, ECB and other central banks will start to raise rates. When bond yields begin to return to their long term average expect money to pour out of equities. Until that moment factors such as profits, revenues and growth may have less of an impact on the equity market than you might think.
Who's in Charge?
Revenue vs cost is the major topic of conversation in every boardroom on earth as companies plan their 2010 business model. As we speak the CFO of any business is really in charge for one clear reason. If a CEO cannot tell the CFO what they plan to spend on their cost base and outline a credible revenue estimate based on that spending, the CFO will demand costs are cut back. There is not a CEO on the planet who can with any confidence tell you what 2010 revenue will look like at this moment given the huge uncertainty surrounding the global economy.
As a result cost considerations are dominating business models, with jobs and investment being cut. Sooner or later though firms will get to the point where there are no more costs to be taken out. The CFOs leadership of business community will be at an end and it will be time for the CEOs to step up. Their task will be to begin the journey back to revenue growth and this will be the story that dominates either the Q4 or Q1 2010 earnings season.
The problem facing the CEOs is: when do you decide to put your foot on the accelerator? Do it too soon and your reputation is lost, do it too late and you risk others in your industry getting a head start and taking market share from you when things pick up. This is a very tough call given even the most optimistic economist would be hard pressed to predict anything other than a U-shaped recovery and many are talking about an L-shaped recovery or the dreaded W- shaped.
The Good, the Bad and the Ugly
Whatever letter of the alphabet you believe the recovery will look like when it comes, if you are investing in individual stocks watch what the CEOs are saying about the coming year. The sensible option is for them to say nothing citing poor visibility for their sector and then keeping the market updated as things become clearer. Keeping your options open implies to me that the business leader has, like the rest of us, very little idea about how the events of the last two years have changed the world.
Those firms who see signs of recovery now, for example due to exposure to a resurgent Chinese economy or better demand in the technology sector, may be right. If they are, then congratulations on the brave call are theirs. If they are wrong, then losses on the stock as the firm disappoints, added to the wall of money leaving the system when things do pick up, could be very bad for your financial health.