Don't Get Suckered by "Good" Earnings

In the market this week, it’s earnings, earnings and earnings. The Dow rallied big yesterday, up 2.1%, straight through 9,000, to its highest level since November. The S&P and Nasdaq were even better, up closer to 2.5%. Just as in the rallies over the last two weeks, blue chip earnings led the way… surprises from 3M, Hershey’s, eBay and Ford grabbed the spotlight this time.

Today won’t be so pleasant. It was Amex’s, Microsoft’s and Amazon’s turn to show their second-quarter hands today… and keeping with poker parlance, they were holdin’ rags. The market is consequently just below break-even as we write.

“The broad stock market,” writes Dan Amoss, “doesn’t see a difference between earnings achieved by cost cutting and earnings achieved by sales growth — especially in the consumer discretionary sector. Earnings achieved by cost cutting tend to be one-time in nature. These do not deserve higher multiples. The latter — earnings driven by sales growth — certainly merits higher multiples. We have seen very little of this, outside of unique companies like Apple.

“This is very important to keep in mind, because the rally in the market since the March lows is entirely driven by expansion in price-to-earnings multiples, not growth in earnings. This type of rally is fine if we’re at a trough in earnings and earnings are about to come roaring back as the economy recovers. But this type of earnings recovery is not going to happen. In the consumer discretionary and financial sectors, the market has gotten way ahead of itself. I expect this to correct itself as the fall season arrives.”

The Daily Reckoning