Published May 29, 2009

Just how robust will earnings be next year?

By R SIVANITHY

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IT appears that the pressing issue as far as stockmarket investors are concerned is either a) is this rally for real? or b) do budding 'green shoots' or a slowdown in the pace of economic deterioration signal a V-shaped recovery and if so, does this therefore justify buying heavily?

Both questions are undoubtedly important and indeed, investors have bet large amounts of money on the answer to either being 'yes'.

The crucial issue, however, one which observers - analysts and commentators alike - have not yet fully digested in their eagerness to go green is this: will corporate earnings be robust enough to justify continued rises in equity markets?

The answer depends on how strong economic growth will be in the future. Since there is no visibility for 2011 currently and because stock markets cannot be reasonably expected to discount further than six months ahead, the only estimates that can realistically be used today are for 2010. Doing this, however, presents problems for the green brigade.

Profits tend to expand in line with the underlying economy, so superior profits are logically the product of above-trend economic growth. While no one knows for sure when the US economy can lift itself out of its present mess - housing prices are still falling and unemployment still rising albeit at slowing rates - the current official forecast is for possibly one per cent growth in 2010.

Since this cannot be reasonably considered as above-trend, then by logical extension it's difficult to see Corporate America reporting solid, superior earnings next year. So if we accept that ultimately it is earnings that drive stock prices, the chances are not greatly in favour of Wall Street continuing its uptrend as we head towards the end of the year and into 2010.

Furthermore, as many observers have pointed out, the deleveraging process has only just begun and companies will have to expend lots of time and resources to repair their balance sheets. Although US banks now appear safe from collapse thanks to massive cash injections from the government, independent research firm Institutional Risk Analytics (IRA) recently reported that a staggering 1,575 US banks incurred losses in the first quarter - an abnormally high number which suggested to IRA that the US banking sector is far from as healthy as US officialdom would have the world believe. Investors should, therefore, note that a stable, propped-up US banking sector does not automatically translate to a profitable US banking sector.

As for the local market, much depends on how this region grows in the absence of a sustainable US economic recovery. In this connection, chances are high that in the weeks ahead, brokers will seek to revive the 'Asia is decoupled from the US' theme that sold well during 2004-2006, pinning their hopes on a supposedly resurgent China replacing the US as the engine of growth for this part of the world.

However, it would be wise to extrapolate from the slew of rights issues and placements flooding the market that companies here - as will surely be the case in the US and other parts of the world - are seizing the opportunity presented by the green shoots rally of the past 11 weeks to deleverage by raising large sums of capital that they might otherwise have raised through debt.

While analysts so far have focused on the balance sheet benefits of these capital-raising exercises - most have issued 'buys' for the stocks concerned - the large number of shares being issued will have the effect of depressing earnings per share. If earnings are already going to be depressed by a stagnant economy, this could then result in the rally stalling.

Investors should, therefore, be mindful that it's all very well to bank on green shoots for now, but it is earnings that hold the key to continued market performance. As things stand now, earnings will likely not be as strong as hoped, green shoots nothwithstanding.