Corporate Profit Revival and the Stock Market

In the ordinary course of my investing activity, I regularly try to figure out market sentiment: whether the larger population of investors are positive or negative on share prices moving forward. There are many technical indicators and surveys of fund managers that attempt to quantify sentiment, which all have their pros and cons. There is of course no certain way to know the future no matter how much data you look at.

One big question many are asking right now is whether the economy is truly on a course of sustainable recovery or if there another decline in the offing: the so-called double-dip recession. Out of all the many economic and market indicators that are being paid close attention are corporate profits. They've been rising. Under other circumstances this would give investors some confidence that the recovery is on track and there is therefore reason to be confident of rising stock prices. Unfortunately it isn't quite so simple.

Much of the profit recovery appears to be due to cost cutting, not a resurgence of demand. As any corporate manager knows, the quick route to immediate profitability is to reduce expenses since (to simply greatly) revenue minus expenses equals profit. Not any expense can be cut since produces revenue always have unavoidable expense. If you sell a motorcycle, for example, you need to buy or build the parts, assemble them, advertise, ship product to dealers and provide service.

What you need to do is reduce expenses that don't affect current operations. Some choices include marketing, research and development, defer capital expenditures, and reduce salaries, bonuses, travel and even office supplies. In other words, gamble with the company's future success. If the same pressures apply to a company's competitors, due to broader or global market conditions (such as now) the risk may be muted. Getting it right is no easy task since the company may miss the economic turn or some new innovation and therefore be poorly positioned during the recovery. Failure to invest in employees or production capacity runs risks incurring loss of talent and production interruption due to equipment failures. That, in an ideal world, is why senior managers are paid the big bucks, to make these critical decisions.

From the outside, as ordinary shareholders, we have to ask if the last quarter's profit rise is sustainable or an anomaly due to expense reduction that cannot be repeated. More precisely, if the recession continues, profits and share prices may very well decline again within another quarter or two. Believing that, it would make sense to sell into the current market rally. However if we instead believe that the recession is ending it makes sense to buy, or at least hold positions, since prices are bound to rise throughout the remainder of the year and beyond. Indeed, share prices may be jet-fueled by a combination of lower expense and increased revenue. But only until companies are convinced the recovery will stick and they increase employment and resume capital expenditures.

On purely technical factors I admit to feeling bullish on the market, even in the middle of the summer doldrums and their low trading volumes. When I pored over numerous charts on Monday -- some that I own but most that I follow and I believe act as useful indicators -- I noticed that many stocks, but certainly not a large majority, are near or testing their 50-day exponential moving averages. This proves nothing except that, for these stocks at least, they are at a decision point. Or more precisely, investors in those stocks are at a decision point.

Banks mainly look good, but not all. Gold looks poor (unfortunately I hold a miner in my portfolio), while many staid industrials and more-exciting technology stocks look set to run higher. This is very much a non-rigourous view of the market, just my impressions from lightly skimming over some of the mass of market data.

I don't know what will happen next except that it will be important. August may provide more definitive answers as the nascent trends are either confirmed or fail.