In 1945, the delightful musical “Carousel” debuted at the Majestic Theatre in New York. In 1956, it became a movie. Written by Rodgers and Hammerstein, the play contains a number of memorable tunes, including “June Is Busting Out All Over.” This melody serves as a delightful backdrop to all of the earnings reports that have been issued recently.
The business and popular press are reporting that third quarter results are showing great improvements in the bottom line. Estimates are that quarterly earnings will rise by 20 percent to 30 percent over last year’s third quarter.
This seemingly healthy jump has for a variety of structural reasons, including increased productivity, a falling dollar, low interest rates, and maybe even felicitous effects from President George W. Bush’s tax cuts. So, yes, the recent earnings news has started a fire.
Given this fortuitous turn of events, why has the stock market not responded (except for the tech sector, where investors don’t care whether corporations produce any income)? One might think that the stock market should be booming with these kinds of earnings reports.
There are at least three reasons for this recent stall in the stock market, despite the rosy earnings picture.
They are: Markets tend to be forward looking; the markets might perceive relatively low quality of earnings; and the markets might have imposed additional increments to the cost of capital. Let’s investigate these sources further.
The first possible cause for the markets not reacting positively to the spate of good earnings reports is that the financial markets are forward-looking. Some time in the past, the markets peered into the future and perceived favorable income numbers. If they did, then one can conclude that financial markets have already factored these data into the stock prices.
There is more, for if the markets do, indeed, peer into the future, then the present declining stock prices might reflect some future downward trends. Perhaps market participants expect less in terms of productivity gains or fewer declines in the value of the dollar.
Possibly the markets are predicting an upturn in the inflation rate. Maybe financial markets believe that whatever economic stimuli the tax cuts provided are beginning to run out. In short, the financial markets appear to be forecasting some troubles in the future.
The second potential explanation for the pause in the stock markets’ action is that the earnings growth may not reflect high-quality earnings. We find one bit of evidence for this rationalization in the difference between operating earnings and net income — there seems to be all kinds of accounting “junk” that exists between the two numbers.
One wonders about the persistence of these special items, and thus the future growth in earnings.
Another piece of evidence may be found by contrasting corporate earnings and cash flows from operating activities. When the two are close, earnings quality is high, and vice versa. Today, accruals are beginning to climb again, which exposes the dangers that these earnings may have some hidden risk.
The third budding foundation to clarify why stock prices aren’t increasing, given the earnings growth, is the rise in corporate costs of capital. This comes about because of the volume of recent evidence that some business executives lie to the investment community. In the same way that investors and creditors add risk premiums to their required costs of capital to accept risky securities, these same investors and creditors want compensation for the incremental risks that are due to managerial prevarications.
Of course, corporate America can reduce these costs by insisting that all managers disclose the truth, and then policing the financial reports against miscreants.
Earnings might be busting out all over, but stock markets are cautioning us to slow down. The future might not be as bright, the quality of earnings isn’t so hot and accounting scandals have increased the cost of capital. To impress the stock markets will require more than just rose-colored earnings.
J. Edward Ketz, an associate professor of accounting and MBA faculty director at Penn State’s Smeal College of Business, recently wrote “Hidden Financial Risk” (Wiley, 2003).
