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Earnings season: A mixture of euphoria and dread

The early birds of earnings season must have gladdened the hearts of equity players, many of whom fear the remarkable rebound of 2009 is doomed unless the corporate world starts producing the growth needed to justify current prices.

Such U.S. market heavyweights as Intel, Google, JPMorgan and Goldman Sachs all handily beat the third-quarter forecasts. And Apple is sure to join the hit parade this week.

This continues a trend. It was the unexpectedly stronger corporate profits of the second quarter that propelled the markets to their stunning rally and prompted the more bullish types in the investing crowd to belt out some version of Let The Good Times Roll.

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But we are coming to a key juncture. The slew of positive surprises shows only that plenty of companies know how to hack and slash their way to decent numbers even when sales fall off a cliff. Flat or falling wages and enthusiastic cost-cutting in a recovering economy are a recipe for fatter profits.



We're getting back to more normal levels of risk expectations, and that shows up in credit spreads as well. That's a very healthy thing. But now, there really has to be growth again, rather than just pure cost-cutting. Michael Mauboussin, chief investment strategist at Legg Mason Capital Management


The question is whether the economic footing is sound enough for businesses to take the next step and actually rebuild revenues.

"Now, we're in the next phase," says Michael Mauboussin, a keen student of market behaviour from his vantage point as chief investment strategist at Legg Mason Capital Management in Baltimore, Md.

"We're getting back to more normal levels of risk expectations, and that shows up in credit spreads as well. That's a very healthy thing. But now, there really has to be growth again, rather than just pure cost-cutting."

Third-quarter earnings "will give us some sense of the fourth quarter and then 2010. We do need to see top-line growth for this market to continue to do well."



Take a look: Reader discussion with Michael Mauboussin:



Meanwhile, the market may well resemble a fairground roller coaster, as more earnings pour forth in the days ahead. Even in the best of times, earnings season produces a singular mixture of euphoria and dread, as investors digest the latest hits and misses and try to get a fix on what to expect in the future. And we are still a long way from revisiting the best of times.



This earnings season is bound to bring more surprises, both good and bad. If you follow Mr. Mauboussin's prescription, you'll do your homework, analyzing whether the stock price is justified by sales, profit, operating margin and other key measures.


We have already had a smattering of market-depressing results, led Friday by General Electric, whose profit plunged more than 40 per cent. Then there was red-ink-drenched Bank of America, which chalked up another $2-billion (U.S.) or so in losses, even as it prepared for the exit of its chief executive officer, Ken Lewis, without any of the $1.5-million in parting salary he had expected but with a pension, shares and other goodies reportedly worth more than $100-million

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Mr. Lewis will have lots of time to work on his memoirs, which he ought to call How to Prosper When Your Shareholders Lose Their Shirts. Merrill Lynch's ousted boss, John ("I should have bought the office furniture at Ikea") Thain could write the foreword.

It's too bad Mr. Lewis ran his bank off the rails before Mr. Mauboussin finished his latest book, Think Twice (Harvard Business Press). It's all about how to avoid making really bad decisions. And it applies to individuals, as much as to captains of commerce.

"When we look to solve problems, almost all of us take what's called the 'inside view,' " says Mr. Mauboussin, who, when he isn't strategizing about investments, teaches securities analysis to Warren Buffett wannabes at Columbia University. (Mr. Buffett took the same course in 1950.)

"We gather the information that's available to us. We impose our own views of things and then we project them going into the future. This is how your mind wants to do things."

Instead, what we should be doing more often is taking what's called the "outside view," and asking what happened when other people faced the same situation.

"Almost always, the outside view gives you an answer that's more pessimistic than the inside view."

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As an example, he cites a bullish report on Amazon.com that projected 25-per-cent annual growth for the next decade. The story was convincing, until Mr. Mauboussin looked at the forest, instead of the trees. "How many companies in history have gone from that size and grown at that rate?" he asks. "The answer is only one. And it was called Wal-Mart."

This earnings season is bound to bring more surprises, both good and bad. If you follow Mr. Mauboussin's prescription, you'll do your homework, analyzing whether the stock price is justified by sales, profit, operating margin and other key measures.

Oh, and avoid listening to the pundits, except for entertainment.

"You wouldn't rely on individual ants to know [the big picture]in the colony. Yet every day, we rely on the ants on CNBC to tell us what's going on. That's a big error."

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About the Author
Senior Economics Writer and Global Markets Columnist

Brian Milner is a senior economics writer and global markets columnist. In a long career at The Globe and Mail, he has covered diverse business beats, including international trade, the automotive industry, media, debt markets, banking and the business side of sports. More

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