Friday, September 08, 2006

THE SHORT VIEW By John Authers - More bad news for the economy

THE SHORT VIEW By John Authers
Copyright The Financial Times Limited 2006
Published: September 8 2006 03:00 | Last updated: September 8 2006 03:00

If corporate America has bad news to get off its chest, we can expect to hear it soon. The third quarter will be ending in three weeks, and the "pre-announcement" season, in which companies try to massage expectations down to a level they can reach, is almost upon us.

Even without any attempts at massaging expectations, the second quarter was a huge surprise on the up-side. With almost all the S&P 500 having reported, 70 per cent produced earnings ahead of expectations, while only 19 per cent disappointed. Typically, only 60 per cent manage to surprise on the up-side. Overall earnings were up 16.3 per cent, an impressive figure by any metric, and far ahead of estimates. Strong earnings have been a key factor in keeping the world's main equity indices in positive territory for the year.

However, changes in earnings estimates over the last few weeks suggest that analysts are growing less optimistic. Last month, the proportion of earnings estimate revisions that were positive dropped below 40 per cent - the first time this has happened in more than three years. That timescale coincides with the beginning of the remarkable run of profit growth in the US. Last quarter was the 12th in a row where profit growth exceeded 10 per cent. The record is 13 consecutive such quarters.

Apart from the earnings revisions, there are other technical signals that suggest it will be difficult to break this record. Richard Bernstein of Merrill Lynch says recent moves in the Treasury yield curve have left it completely inverted; from the three-month treasury bill to the 10-year bond, the longer until a bond matures, the lower its yield. This has happened four times since 1970. On each occasion, it was followed by a fall in corporate profits. He suggests that earnings expectations for the next year are too optimistic.

And Robin Evans, global strategist at Fox-Pitt Kelton, says downward earnings revisions tend to correlate with high levels of volatility as measured by the Chicago Board Options Exchange's Vix index. The moving average for the Vix is rising following the sharp correction many markets endured in May - another bad sign for earnings.


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