Big rally doesn't mean all is well

By Jon Markman

When you're worried that a scary-looking stranger on the street might slug you in the face, that's probably an irrational fear. When you're worried that a serial killer who's got you by the throat might murder again, you've got every reason to be concerned.

Many investors often find themselves in the first category, blindly dumping stocks at the slightest provocation, as they did in July 2006, just before a rapid 25% run-up in prices. In retrospect, anyone can see that was dumb.

But investors who have dumped stocks lately have some pretty persuasive facts on their side, starting with the mother of all rationales: Earnings stink and probably will deteriorate more over the next six months than the consensus considers likely.

What that means is that now is no time to plow money back into the market on the assumption that it has hit bottom. The better strategy, which I'll explain in more detail below, is to ignore any short-term rallies -- unless you're an active trader -- and wait for further deterioration in the first half of 2008 before committing fresh funds.

Not the only thing to fear

Here's the deal: About 90% of companies have reported third-quarter income already, and it wasn't pretty. Operating earnings per share fell 8.5% from last year. Compare that with the 9.6% rise in earnings in this year's second quarter and the 11.6% jump in last year's third quarter. According to Merrill Lynch statistics, the July-through-September period was the worst three months for earnings since the post-9/11 days in the fourth quarter of 2001. If you look at just the change in earnings from one quarter to the next, operating earnings dropped 12.4%, which was the worst sequential change since 1989.

• Discuss on Jon Markman's message board: Are you buying now or waiting?

The most meager results, as you might suspect, were posted by consumer-discretionary companies such as home builders, automakers and retailers. Their earnings were down a stunning 39% from last year's third quarter. Next-worst were banks and financial-services companies, which make up a third of the market capitalization of the major indexes. Their earnings were down 33% in aggregate in the third quarter.

These results were not merely a blip or something to be shrugged off as "just one of those things." There's a gaping hole where profits in corporate America used to be, and that means we are staring into the abyss of an earnings recession. Whether that means the U.S. economy trips into a full-blown production recession is another matter. But an earnings recession is a serious problem by itself because profits drive the entire business cycle.

You see, companies with growing earnings divert much of their income into spending on new plants, equipment and technology, as well as into the hiring of employees. When profits plunge, in contrast, companies tend to stop dead in their tracks -- slashing planned capital-improvement projects, dumping employees, halting computer software and hardware upgrades, and pulling back on advertising.

• Video: The Fed's mixed message

Merrill Lynch economist David Rosenberg notes that the last two times operating profits plunged so deeply into the red were the fourth quarter of 1989 and the fourth quarter of 2000. You might recognize those periods as coming just before the last two recessions.

Déjà vu disappointments

Though these figures alone get your attention, consider that operating income strips out all the write-downs and charge-offs that occur in a quarter to provide a more normalized view of a company's health. When you instead look at "reported" numbers, which are the ones to which the market typically reacts, earnings per share plunged 28% from last year's third quarter.

If you annualized those numbers, just to see what companies' profit pictures would look like if they happened for three more quarters, you'd get a 75% plunge in earnings -- the worst such figure since the bear market days of 2002 and the fifth-worst since 1945. Rosenberg says this puts the recent slide on par with some of the greatest corrosions of income in the past five decades, including the Latin American banking crisis and the savings-and-loan debacle of the 1980s.

Continued: Big disappointments ahead

 1 | 2 | next >