During the last six months, the markets have been more daring and exhilarating than many of the fastest and tallest roller coasters. Not only have we seen significant drops, there have been two periods of significant rallies as well. The latest rally started on March 10th and it is unclear whether the rally is over, taking a pause, or getting ready for another leg up.
Many economists and market analysts expect we have seen the bottom for the economy. Clearly, there are some that expect this recession to last several more months or perhaps years and that the economy may become even slower. However, at this time, this group appears to be in the minority. Every recession needs time to run its course. But, what does that mean?
Few companies have been idle during this recession; many have been taking action in response to the slowdown. This action would include slowing or cancelling expansion plans, instituting wage and/or hiring freezes, layoffs, divesting themselves of non-profitable units/divisions, as well as many other steps. All of these actions are generally designed to reduce costs and preserve cash in order to get through the recession.
As corporations work through the process, the first quarterly reports issued after any action is taken in response to the recession often indicates lower than expected earnings or higher than expected losses. This can be caused by writing off additional expenses associated with the course of action the business may have taken. Thus, an additional quarter may be needed before the impact of the course of action can be seen.
But with time, the economic cycle can start to show signs of recovery. The next quarterly report issued by the businesses may start to provide glimpses into the future. This could be increasing revenue or better than expected profit/loss reports. The out-of-ordinary expenses associated with workforce reductions or other significant changes may now be zero, thus allowing the quarterly earnings report to provide a greater indication of the firm’s direction and perhaps the economy. As an example, information reported by Caterpillar can be used since it reported first quarter 2009 results this week.
Before the markets opened this past Tuesday, Caterpillar reported a loss of $112 million or $0.19/share for the quarter vs. a profit of $922 million or $1.45/share for the prior year. However part of this loss, $558 million, was the result of additional expenses linked to the workforce reduction Caterpillar had recently taken. Without this deduction, it would have reported a profit of $0.39/share for the quarter. While the actual results were better than many analysts were expecting, this is only part of the picture. The comments Caterpillar made regarding the balance of 2009 are also very important. At present, the firm is still forecasting a profit for the year but on lower sales.
The report from one firm clearly does not shape the recovery. However, this week and next, almost a forth of the companies in the S&P 500 will be making quarterly reports. As all of this information is digested, the economists as well as analysts will be tweaking their forecasts for the balance of 2009. This new information may also create more volatility in the markets since it is doubtful all of the new information will be “leaning” the same way.
As this information becomes known, many stocks may actually trade lower even though they may have reported better than expected earnings. This is known as “trading on anticipation and selling on news.” By the time the actual news is released, the stock value may have already moved up considerably and thus, trade lower as those who bought early sell out. This can create a two steps forward (or up) and once step back (or down) effect. The rally that started on March 10th is certainly not old, but prior to Monday’s decline was up almost 30 percent in about six weeks.
To put this into perspective, the long-term average performance of the markets is 9 to 11 percent per year. Not 30 percent in six weeks. To many professionals, the market was getting ahead of itself and prices had moved up too far thus raising the possibility of a correction. The question becomes what will happen to the rally? Is this a brief pause with the rally to resume, or will the markets once again change direction? How the markets interpret the earnings reports in the weeks and months ahead will be the determining factors. But, it is this rally - pause/correction - rally that should be expected for the next several quarters if not years. Each rally and correction will vary in length and amount up or down, making it better to be in for the long haul rather than short-term changes.
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