The Manager's Commentary - September 2011

WHAT IF THE OTHER SHOE DOESN’T DROP THIS QUARTER?

Back in the giddy late 1990’s, it was common to hear analysts and commentators describe stocks as being “priced for perfection” … as history would later reveal, this lofty assessment would actually turn out to be a gross understatement for vast portions of the market. Today, we find ourselves in a fairly opposite state: while stocks aren’t necessarily priced for disaster, they are certainly valued with the expectation of disappointment. The still fresh memories of 2008, combined with the myriad macroeconomic worries that now pummel us daily, make it understandable that investor sentiment is, at best, reticent. Despite these valid concerns, however, most corporations have been faring remarkably well, with earnings growth rates remaining surprisingly strong right up to the most recently reported quarter. One of the drivers of this earnings resiliency has been a persistent expansion of corporate profit margins to near record levels (see first chart). Because this margin growth has come primarily through cost cutting, (which can’t continue indefinitely), many observers have been predicting that further earnings gains will be unattainable without some help from the top line. Given the moribund state of the economy, it was widely expected that Q3-11 results (to be reported over the next several weeks) would begin to reveal this pressure. A couple of key indicators undermine such a gloomy outlook, however. First, the 19 S&P companies which report their third quarters in August showed no slowdown in profitability, with the median firm exceeding expectations by 3%. Second, those businesses due to release results in the coming weeks have been conspicuous in their silence. In fact, the number of earnings warnings registered by S&P companies is sitting near a 10 year low (see chart to right). This is important because, as Brockhouse Cooper showed in a recent study, the volume of negative preannouncements carries a strong predictive quality for subsequent reported earnings – when warnings are few, actual earnings almost always exceed expectations. So, with markets pricing in the worst, there is a good chance that reality will prove far less dire than what’s being forecast, perhaps opening the door for a late-year rally.

Dixon Mitchell Investment Counsel
September 30, 2011