Markets are up. Earnings are down. Here’s what’s really going on.
By Neil Irwin,
Earnings season is underway, and it’s looking to be a doozy. The Standard & Poor’s 500 stocks are forecast to have suffered a cumulative 2.7 percent drop in profits, according to FactSet, the first decline in 11 quarters.
But there is a mystery hanging over the markets: In the quarter, the S&P 500 rose 5.8 percent.
In other words, investors are paying more for shares of companies that are making less money. To understand why, it helps to look at the details of the first major industrial company to report its third-quarter results, Alcoa, which released its earnings numbers Tuesday afternoon.
Alcoa manufactures much of the aluminum that makes the modern world work; its metal goes into jet airliners, automobiles, buildings. From July through September, aluminum was not a terribly lucrative business. The company had a loss of $143 million in that quarter, compared with the $172 million profit it reaped in the same quarter last year. The loss includes one-time costs from legal settlements, but even excluding those, the company earned only $32 million in the quarter as revenue declined more than 9 percent, to $5.83 billion.
It is no mystery why the aluminum business is looking so weak: Europe is in a recession, China and other emerging-market economies are slowing, and the U.S. recovery has remained sluggish. Overall, Alcoa said Tuesday, it expects global aluminum demand to rise only 6 percent this year, down from the 7 percent it projected as recently as July. (Growth was in double digits in 2010 and 2011.)
Still, Alcoa’s stock managed to eke out a 1 percent gain last quarter, a more dramatic display of the pattern of the overall market. The explanation is buried in the company’s presentation to investors.
In the past year or so, Alcoa executives said in a conference call and to investors, the price of aluminum on the London Metal Exchange has cut the usual ties to the metal’s fundamental demand and supply. Instead, the share price is now responding to the latest headlines on government economic measures, especially to actions taken by central banks, that affect the world economy overall.
To demonstrate its point, Alcoa used a slide show that linked big moves in the price of aluminum to a Chinese stimulus plan announced Sept. 7, a German court ruling in favor of Europe’s bailout efforts on Sept. 12 and the U.S. Federal Reserve’s announcement of its “QE3” program of bond buying on Sept. 13.
“The market today is basically driven by headlines and not market fundamentals,” Alcoa chief executive Klaus Kleinfeld said in the conference call.
Over the course of the summer, even as the global economy grew more perilous, many of the world’s central banks began pulling out more weapons to deal with it.
In Europe, that meant an open-ended European Central Bank program to buy up the debt of financially troubled nations as traders were betting that the euro zone would rip apart. In the United States, that meant the Fed’s pledge to keep easy monetary policy in place until it sees meaningful progress on lowering unemployment.
The simplistic version: As central banks fire up the printing presses, some of the new money they create makes its way into both the stock market (driving up the stock price of Alcoa and other companies, despite weak supply or demand) and the commodities market (triggering the rise in aluminum prices that Kleinfeld was talking about).
But there’s probably more to it than that. If this was solely a case of additional money pushing up stock prices, it probably wouldn’t have much of an effect on volatility measures. The money-printing could drive prices up and still leave investors just as worried about future swings in stock prices as they were before.
But the Chicago Board Options Exchange Volatility Index, known as the VIX, has been falling all summer. It is now below its levels in July 2007, when the financial crisis began, meaning investors are less concerned that there will be wild swings in future stock prices.
That suggests that the central banks have succeeded not only in propping up asset prices through their bond-buying programs but also in reassuring the financial markets that the banks have the world’s economic problems under control.
Investors are willing to pay more for shares that earn less because they’re more confident about taking the risks than they were just three months ago.
Now, we just have to hope that the markets are right on that count.