On Earnings and Outlooks

Last week, James Surowiecki made what I thought was a very good point about about the little mini-bull we've enjoyed this past month, specifically in response to the "sucker's rally" crowd:

What's perplexing about this argument is that it seems to assume that investors are averting their eyes from all that's wrong with the current economy, and have driven stock prices up to unusually high levels. But they haven't. The S. & P. 500 is now about ten points lower than it was in early February, and it's about five per cent below where it was when the year started. That doesn't mean current prices are justified. But it does mean that stock prices are not, as one recent analyst suggested, "in the stratosphere."

Of course, if you believe that stocks were significantly overvalued back in February (or back in December), then you probably believe that they're still overvalued today. I would argue that there are good reasons to believe that the economy, while still very weak, is much closer to a bottom than it was two months ago, and that the Obama Administration's management of the crisis--which we could only guess at in January--has been a net plus for the economy (and therefore for the stock market).

Other analysts are arguing that the case for a rising market is there, but that this latest rally got ahead of itself. That's not too hard for me to believe. The economy is still shaky enough that it will occasionally crank out a solid week's worth of bad news, which is enough to sober up even the bulliest investors. What strikes me as truly odd are stories like this, which announce that disappointing first quarter earnings signal that recovery isn't on the way after all. It's like when S&P releases the latest Case-Shiller data, from three month's previous, and journalists everywhere declare that the housing market is as bad as ever, as if January and April were indistinguishable.

Maybe there are investors out there who determined that since conditions now, in the second quarter, look more positive, such that recovery, in the third or fourth quarter, looks more likely, the first quarter must not have been so bad after all. But it was very, very bad. Indeed, in some ways the depth of the first quarter decline has made me more optimistic about conditions going forward; firms slashed production so aggressively, and labor forces so brutally, that it's not difficult to imagine them needing to increase output and hire some workers in the months ahead as output stabilizes.

Statistical releases in the first three months of this year routinely came in below expectations. The economy sank faster than most of us anticipated. We should not, therefore, be surprised if firms announce some really awful earnings for that period. That's no reason to conclude that recent optimism has been misplaced. The fundamentals remain the same -- the international policy reaction to the shock has been strongly expansionary, and so we should not expect the downturn to be anything like as long or as deep as the Depression. We are closer to the end of output contraction than to the beginning.