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Retired chief investment officer and former NYSE firm partner with 50 plus years experience in field as analyst / economist, portfolio manager / trader, and CIO who has superb track record with multi $billion equities and fixed income portfolios. Advanced degrees, CFA. Having done much professional writing as a young guy, I now have a cryptic style. 40 years down on and around The Street confirms: CAVEAT EMPTOR IN SPADES !!!

Wednesday, July 27, 2005

Earnings Trend Factors

I use a variety of economic data to try and track earnings
growth and momentum on a monthly basis. Some observations:

The recovery of SP 500 operating profits off the Q2 '01
recession low was very powerful, with quarterly earnings
basically doubling to $18. through Q1 '05.

Sales rose far more rapidly than costs, leading to sizable
improvement in profit margins. But other specific factors
were important, namely a weak dollar, large inventory profits
for basic industry and especially for oil and gas producers,
and the fact that many companies took huge writeoffs over
2001-02 that were not captured in operating earnings.

As is normal, earnings momentum is now decelerating after
such a remarkable bounce.

Business sales growth measured yr/yr peaked at nearly 10%
during Q2 '04 and has now slowed to the 6-7% area. This
still beats estimated cost growth of 5.5-6%, so gross margin
is still expanding, although far more modestly.

Currency translation gains are evaporating rapidly reflecting
a much stronger dollar, and basic industry inventory profits
have also levelled off. On the plus side, oil and gas
inventory profits are still surging.

Forecasters expect yr/yr earnings growth for the SP500 to
average roughly 10% each quarter through the end of 2006.
This is a reasonable projection provided sales can continue
to grow at 6-7% and margins can continue expanding via
further productivity gains.

What is troubling about the consensus expectation is that
it implies absolutely ingenious and faultless fine
tuning of the economy by the Fed. The continuous 10%
growth expectation is too high relative to the current
direction of monetary policy (now restrictive). I sure
do not know if the Fed can move through policy with such

I guess I will be following my earnings indicators more
closely than I have recently, because the market seems to
me to be priced heavily on the assumption of strong earnings going forward.

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