Be afraid. Main Street is having a major disconnect from Wall Street. Along with Wall Street, our government, Federal Reserve and the media are too blame. The wool is been pulled over your eyes!
While the markets continue to soar, I sit back and shutter. Why you ask? Because for those of us that really analyze the numbers, it is a very scary thing to behold. For the common investor, they will simply look at the earnings per share and do their P/E calculations. This tells them whether or not a stock is cheap relative to the S&P historic multiples. If it were only that simple these days…. Accounting changes for financial firms have given them the ability to knock the earnings out of the park. Recently, JP Morgan Chase (JPM) and Goldman Sachs (GS) both blew away estimates. However, does anyone really wonder what the accounting changes actually did to these numbers? Why AIG was saved? Or look at the credit card defaults and risk these companies face going forward? Or better yet, does anyone note the new risks companies like Goldman Sachs are now undertaking in order to turn such big profits? I continue to shutter. The next disaster may be in the works.
While the financial companies are in a league of their own when it comes to earnings, I am here to discuss the earnings of other companies, non financial firms.
What has me so scared for the next two years? While most companies are blowing out earnings per share (EPS) numbers, they are missing on revenue. So how are they able to beat on earnings but then miss on revenue? Simple. Cutting costs. Now think about this. How are they cutting costs? Obviously, as the unemployment numbers tell us, they are cutting jobs. In addition, they are cutting out projects that were not profitable, buying less inventory, trimming the fat in other words. While this is a smart thing to do to make these companies more efficient, in an economy that has unemployment spinning out of control, it may not be the best scenario. Each person that is laid off spends less money. With less money spent by that one person, the trickle down effect is drastic. Imagine how each person with a job spends a certain amount, each place they spend, someone else must work and is paid. They spend, others need jobs and the cycle continues. So imagine the effect of just one layoff.
In addition, cutting costs can only go so far. Think of it as a company on steroids in the near term. Yes, they look very strong but wait until certain things start to shrivel or the steroid supply ceases. This is right around the corner, once cost cutting can go no further. Eventually, there is nothing left to cut. So while earnings are blowing away estimates, the real key is to watch the revenue numbers. Within a quarter or two, earnings will start to lag as revenue continues to decline and there are no more costs to cut.
In many ways it is a double edged sword. Near term, the earnings are blowing out expectations, but as a result of the cost cutting, unemployment is spiking higher. This will cause the recession to last much longer. As I have pointed out, cutting costs to boost earnings is not showing the true nature of a company.
To give proof of this you only have to look at the earnings over the past couple weeks. Pick out any handful of companies that reported earnings. Most have blasted through earnings yet revenue was in line or missed.
Let’s start with EI DuPont de Nemours & Co. (Symbol: DD). Analysts had projected that they would make $.53 on $7.10 billion in revenue. The stock reported earnings excluding items of $0.61 which beat estimates. However, revenue came in light at $7.09 billion.
Next, let’s take a look at Coca Cola (Symbol: KO). Analysts estimated they would make $1.00 per share while raking in $10.95 billion in revenue. The company reported earnings per share at $1.02, beating by $.02 but revenue missed, coming in at $10.59 billion.
Last, take a look at Chipotle Mexican Grill (Symbol: CMG). Analyst expected earnings of $.88 per share on revenue of $391.2 million. When the company reported, they blew the earnings out of the water at $1.10 per share. However, revenue again came in light at $388.8 million.
These are just a few of the many earnings beats but revenue misses. As of now the market has swept the revenue misses under the rug. A rally on hope and ignorance continues. It will only last so long. The average investor has no clue as the media is pumping the recovery and the great earnings results. The cost cutting can only last another quarter or two and it will level off. After that, earnings could see a massive plunge. Contrary to many, I see no recovery starting yet. As long as the unemployment rate climbs, people will hold back from spending, not buy houses and continue to struggle to pay their bills.
Unfortunately, earnings numbers do lie and the wool is being successfully pulled over the average investors eyes. They have bought in, hook, line and sinker, putting their hard earned money at what could be a major top.
By: Gareth Soloway
President & CFO
InTheMoneyStocks.com
