As we get into earnings season, a big reason for the recent stock surge has been due to better than expected earnings. Each quarter this year has seen the percentage of companies beating estimates increase. Given the collapse of the economy in Q4 2009 into Q1, we would expect things to get better. But it's been mainly achieved by cost cutting and layoffs. As the NYT reports, "Overall selling and administrative costs among S&P 500 companies fell 5.7 percent in the second quarter versus the period a year earlier.....This represents far more drastic cuts than were undertaken in the recessions of 1991 and 2001."
The point is that Q3 is going to be all about cost cuts and less about revenue growth. As an example, Alcoa beat Q3 estimates today (ex-items), but revenue was $4.62 billion from $7 billion in the year-ago period, but still above street estimates of $4.55 billion forecast. Here's my point: the company had overhead and procurement savings totaling some $375 million and $1.61 billion.
At some point, companies are going to have to derive better earnings from increases in revenue rather than decreases in costs. Since costs have been cut aggressively, an incremental increase in revenue will look great and help propel earnings higher. Our chief investment officer at Harris Private Bank Jack Ablin says, "Once sales kick in, this will have a leveraged effect on earnings." He thinks this happens in either Q4 or Q1 2010.
Also, keep an eye on companies seeing a pop to earnings from their exports. Clearly, the companies with big overseas sales are going to do extremely well as the US dollar has tanked. This has continued into Q4 and I believe we'll see further erosion of the buck to assist these sales further.
Now, a lot of the current positive mojo for stocks is cooked into the market as the S&P has rallied over 50% from the lows. What I'm looking for is how equities react when we get better than expected earnings and if those earnings are solely due to cost cuts. The S&P peaked on September 23rd at 1080. We'll need to see guidance out of companies that revenue will be going up or this rally will stall.