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Earnings will need to show revenue growth if rally is to last, experts say

TORONTO - Coming off a week on the Toronto stock market that saw the TSX briefly go above 11,000 for the first time in 10 months, it may seem like investors can finally relax.

TORONTO - Coming off a week on the Toronto stock market that saw the TSX briefly go above 11,000 for the first time in 10 months, it may seem like investors can finally relax.

But investment advisers are cautioning that the recent rally - which has been largely based on a stream of positive second-quarter earnings results - doesn't have the fundamentals to sustain itself.

So far, three-quarters of American companies' quarterly earnings have topped expectations, as have more than half of Canadian companies.

But Gareth Watson, director and Canadian equity adviser for Scotia McLeod, said he would append "an asterisk" to these better-than-expected results if he could.

"While earnings expectations have been beaten, revenue expectations have not been beaten as much, which to me indicates that the earnings that are being reported are better than expected because of cost cutting and not because of revenue growth," Watson said.

Although it was heartening for investors to see many major companies reporting an improvement, Watson cautioned that the rally experienced in recent weeks isn't sustainable unless companies see some real growth.

"The only way I think you'll see this market sustain itself is if in the next few quarters these corporations really start to see accelerated revenue growth, because you can't keep cutting costs," he said.

The key to revenue growth is increased consumer spending, but so far the numbers aren't encouraging.

Major U.S. retailers released their July sales data last week, with most companies reporting lower sales as shoppers remained tight-fisted, raising concerns about the back-to-school and holiday shopping seasons.

Official U.S. retail sales data are due out on Thursday.

"You've got to get that spending going again, and the indicators that we've seen aren't necessarily supportive that the U.S. consumer is right back on track to spending again," Watson said.

Still, news on Friday that American employers throttled back on layoffs in July offered a strong signal that the economy is improving.

U.S. employers cut just 247,000 jobs last month, the fewest in a year, while the unemployment fell one-tenth of a percentage point to 9.4 per cent - its first drop in 15 months.

However, Watson cautioned that jobless numbers and unemployment data can be misleading.

"If people give up looking for work, they don't get included, so it doesn't really reflect the unemployed," he said.

Andrew Pyle, an investment adviser with ScotiaMcLeod in Peterborough, Ont., agreed that economic and corporate fundamentals simply don't support the rally markets have been experiencing.

"Markets are pricing in a trajectory that is at odds with the fundamentals and need to re-adjust," Pyle wrote.

CIBC chief economist Avery Shenfeld said the chief driver that has seen the TSX recoup nearly 50 per cent of its losses since its March 9 low has been government intervention rather than real economic growth.

"The extreme fears of a second Great Depression were lifted as governments showed tremendous resolve in tackling elements of the crisis, even at great expense to the public purse," Shenfeld wrote.

However, "we're getting closer to the end of that source of equity momentum" and the next leg of the rally will have to come from improved corporate earnings, he added.

Whatever happens, it won't happen quickly.

"To expect us to really completely have turned everything around within 10 months is just an unreasonable expectation," Watson said.

"It's taken years for us to get this bad, and it's going to take years for us to fix it."

 
 
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