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2.7%  Q1 GDP    4.57%  avg. 30-year mortgage     9.5%  Unemployment

Both Sides Of 'Better Than Expected'

The stock markets have climbed this week boosted by positive corporate earnings, which invariably have been described as "better than expected."

The Dow and the S&P 500 are on pace for a 1 percent gain on the week; the Nasdaq is riding a 3 percent gain.

But are traders living in a fool's paradise if they continue to drive the markets higher by buying stocks based on earnings that are down, say, 50 percent from this time last year, only because they're not down 75 percent?

That's what Diane Garnick, investment strategist at Invesco, said today.

In an interview on Tech Ticker, Garnick says that companies are beating earnings expectations in the first quarter by Draconian cost-cutting, an unsustainable strategy for long-term growth.

More importantly, although companies are beating profit estimates, thanks to the cost-cutting, they are missing expectations for revenue, she says.

Further, cost-cutting via layoffs hurts the economy as a whole, Garnick argues, because the unemployed spend less money.

The Ticker e-mailed Tim Hanson, an analyst at Alexandria's Motley Fool, and ran Garnick's theory by him.

He wasn't buying it.

"Short-term stock movements are all about expectations and when one is speaking in broad terms like 'the market,' it’s difficult to really pinpoint a trend." Hanson wrote back. "After all, if a company is valued for 0 percent revenue growth and 2 percent earnings growth and achieves 0 percent revenue growth and 4 percent earnings growth, it’s obviously going to be worth more in the eyes of investors."

"I don’t think any of the recent stock price increases have suddenly revalued companies as though they’re going to do 10 percent sales growth and 15 percent revenue growth (which is a mistake)," he continued. "The market has just decided these companies do have some cards they can play to cope with the current environment."

Hanson said that Garnick gets it partly right, however.

"The part of what she’s saying that’s correct is that cost-cutting is not sustainable," Hanson wrote. "Eventually you get to the point where you can’t cut costs anymore."

However, he adds: "As for the part that cost-cutting (lay-offs) will cause the economy to get worse, I’m skeptical of that," he writes. "The forces that push on our economy are so many, varied and vast, that some job cuts here and there aren’t going to be a determining factor."

Finally, Hanson adds that this recession is a tough, but necessary, medicine for the U.S. economy.

"Companies learn to automate some processes, hone their capital allocation processes, and do other things that will help them do better over the long-term," he wrote. "Without getting lean every once in a while, we’d end up looking like Europe."

Of course, there remains the issue of a U.S. unemployment rate that now stands at 8.5 percent and may hit 10 percent by the end of the year, some forecasters estimate. Though the former workplaces of the unemployed are likely now more efficient, the unemployed will need new jobs, and that will require retraining and new capital to create new businesses.

In a recession, both are hard to come by.

-- Frank Ahrens
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By Frank Ahrens  |  April 24, 2009; 3:24 PM ET
Categories:  The Ticker  | Tags: Diane Garnick, Invesco, Motley Fool, Tim Hanson, earnings  
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Next: This Week: Consumer Confidence, Fed Meeting

Comments

Do not get too excited by the market steaming ahead. Unemployment losses, production slumps, foreclosures etc etc etc are still happening. More disturbing though is the fact that directors and CEO's of major companies off-loaded $353 million dollars of shares this month compared to purchases by them of less than $44 million. I guess they don't know anything about their companies.

Posted by: psouleles | April 25, 2009 5:10 AM | Report abuse

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