"What will give the stock market some direction again?
Assuming we avoid an important geopolitical event or an accident in the banking sector, direction will most likely come from earnings. The reporting season for the second quarter starts soon.
The value of stocks depends on the profits they generate and pass on to their investors as cash flows. It is obvious that – with many losing their jobs and economic activity declining – revenues will fall. But it does not directly follow that the profits they generate from their revenues will be cut.
Hopes for earnings rest on an expansion of profit margins. Can companies work more profitably as the economy hits bottom and expands?
That has happened before. After drastic cuts to output, inventories have been cut back. This gives companies more pricing power when demand returns. Extremes in the inventory cycle can lead to fast increases in profits.
Industrial new orders, as revealed by purchasing manager surveys, are rising – even if consumer confidence, an important measure of demand, appears to be weak.
The question is whether the current expectations for such a rebound are reasonable. Mr Smithers points out that US profit margins in the first quarter were at historical averages. As margins tend to revert to their long-term mean over time, and had been very high, this suggests a sharp rise in profitability will be hard to accomplish. Further, companies paid out 150 per cent of their profits last year, either by buying back stock or paying dividends. This shows confidence that low profits would be temporary. It also suggests stronger profits will not translate swiftly into more cash to investors.
If profit expectations are low enough, even muted rises could boost share prices. Research by Andrew Lapthorne of Société Générale shows that forecasts were cut in most regions last month, although they rose in the US (largely thanks to the banks), and stayed steady in the emerging markets.
But Mr Lapthorne also shows current expectations imply that margins will recover to historical high points next year.
Such rebounds have happened before. But this recession is deeper than any post-war predecessor, as the shocking jobless totals show. Overhang of consumer debt in the US is another difference from previous recessions, as is the risk of renewed shocks from US housing next year as more variable mortgages reset. These will brake any resumption of spending.
A swift return to high profitability seems possible, but very difficult. That will make it harder for the stock market to advance."
John Authers, "Short view: Panic gives way to relief and a pause for thought", FT 4-5 juli s 22