Corporate Earnings - How China Will Bring Down the U.S. Market

Since the start of the latest rally in March 2009, news about the state of the economy has fueled market movement.

Most of the positive news from the economy came in the form of upward action simply because the news was less negative. Meanwhile, earnings estimates — the one number Wall Street can really control — were constantly beaten by firm after firm across many industries. If you take a good look back at this rally, earnings seasons were positive times for the market.

During that span of time, most companies beat their estimates, but many did not beat their revenue estimates. Major cost-cutting was the reason. However, cost-cutting shows retraction, not expansion, and should not be viewed as a positive thing. Expansion shows growth and potential recovery. But, retraction shows continued recession.

How Low Can the Earnings Bar Go?

To me, companies beating estimates by cutting back was a negative thing, not a positive one. Obviously, led by Wall Street’s influence, the market disagreed with me.

While almost all companies reported numbers that beat expectations — which, as you know, drives the market up — very few actually did so by expanding. That is, most weren’t growing their earnings by increasing their sales as opposed to reducing their expenses.

But, there were a few companies that did report better earnings by actually increasing their sales. They were few and far between, but they did exist, which was viewed as a very bullish sign that the recovery was well on its way.

So, earnings had become the real catalyst to the rally.

Where do we go from here?

Personally, when I try to look forward, I start off by looking at where we are now, not so much in where we were before. I like to look at the present situation and what is causing us to be here. This keeps me from looking back too far in history to a time when things were too different to truly and accurately compare.

To me, it is similar to trying to compare athletes of different generations. Everyone wonders whether the stars of yester-years would be the same level of star today as they were then. Most of the time, the answer to the questions is that the two can’t be compared. They were two very different times.

Recession 2.0

In this vein, we can say the same thing about the comparison between this recession and the Great Depression.

The times that these two events occurred in were so dramatically different that no true, level playing field comparison can be made. So, looking back too far takes you from realism to surrealism … not what you want to do. (Are you hearing me, Ben Bernanke?)

When I am trying to forecast the likelihood of potential future events, I look at back at recent times, not past times. So, my thought process leads me in a specific direction concerning the future movements of the U.S. market and economy.

Knowing the importance and heavily weighted influence that the earnings reports have had on the market recently, my mind is leading me in a specific direction.

What the True Earnings Success Stories Have in Common

The companies that came through with really positive results — not just beating expectations, but with actually good numbers — seemed to have a similar characteristic. That is, they all saw huge increases in overseas sales — particularly in Asia and, more specifically, China.

These companies are the results that most optimists are basing their expectations off of and are using as proof of their predictions.

The increases in sales from U.S. companies skyrocketed from huge increases in demand and a weak U.S. dollar. However, most companies only saw increases in sales in China increase — an average increase of about 30%, which was critical to earnings as U.S. sales decreased about 1% over the same time.

In this past earnings season, several of the bigger blue-chip stocks owed their outcome to China’s rapidly increasing demand. But can China’s demand surge be counted on to carry U.S. companies?

The answer is no. And an emphatic no at that!

China’s Next Move … What Will Yours Be?

China has come out and publicly stated that it is going to put the brakes on its economy. It has already taken several steps to slow down the bank’s ability to lend money out, and the next step is full-blown rate hikes.

China is making every effort to slow down the growth in the economy and prevent an asset bubble from forming and exploding like it did in the United States.

With China hitting the brakes on its economy, Chinese demand is sure to diminish. This will lead to lower sales stats in China, and less profit for U.S. companies doing business there.

This is a major problem because the only U.S. companies that showed any sales growth did so because of China’s demand. Shut down that demand, and earnings get shut down.

Now, you may say that these companies may make up the shortfall in sales in upcoming quarters somewhere else. Well, we already know that the U.S. sales have been decreasing. And, the latest news out of Europe is that growth was pretty much flat.

So, where is the shortfall in sales going to be made up from?

U.S. Dollar in the Spotlight

Further, the U.S. dollar has come off its lows. The news out of Europe concerning the potential credit crisis in Greece — not to mention Spain and Portugal around the corner — has weighed heavily upon world currencies.

It has particularly impacted the euro, and caused a little flight to quality — into the U.S. dollar. So, the dollar has strengthened a bit recently, which is not a positive thing for U.S. companies’ overseas sales.

Now, there is a second negative factor that will have an adverse effect on U.S. companies’ overseas sales in the next couple of quarters.

If it is the growing earnings of U.S. companies’ sales that is fueling the market to higher levels — and those sales were primarily due to the demand growth in China, and China is slowing down decreasing the demand there — then U.S. company earnings will falter. And so should the market.

Tell us what you think here.

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