Beware of the usual smoke and mirrors

Flying the flag for Q3…

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Yes, Q3 earnings season is almost upon us with the usual headline-grabbing improvements in carefully selected reported numbers.

What this season might tell us about the overall direction of everything is, to start the week on yet another pessimistic note, hardly uplifting.

John Authers is once again worth quoting from his Long View column in this weekend’s Financial Times.

The S&P 500 enjoyed bounces of 2-3% in 2000-2008 immediately after the first – to third quarter results were announced, according to a study by Andrew Lapthorne of Societe Generale in London.

But the index, when you take these increases out of the calculations, fell on an average annualised basis of 1.2% – suggesting some economy with the truth in company reporting.

This year’s Q3 season might help to support equity markets until the end of the year if, again, the clever bean counters have been at work – and companies follow their usual practice of under-promising and therefore appearing to over-deliver.

Next year is the problem.

Price/earnings ratios on an operating profit basis are way ahead of where they were in any previous economic recovery since the Second World War, said David Rosenberg of Gluskin Sheff in Toronto.

In other words, companies will have to deliver spectacular profit and/or revenue growth next year to justify current valuations.

The mood in bond markets – where yields indicate expectation of a slow and non-inflationary recovery – is very different.

As we’ve said before on this blog, commodity and equity markets have priced in a recovery which might well not happen in 2010 or even 2011.

Companies across many industries, including chemicals, have made improvements mainly on re-stocking and cost-cutting this year.

It’s hard to see how they can make similar gains in 2010 – particularly in commodity chemicals where we are only just beginning to reach the bottom of a prolonged supply-driven down cycle.

And when equities go in the New Year so could crude, potentially creating another mini de-stocking crisis. This will be nowhere the near the scale of Q4 2008, though, due to much-tighter inventory management policies.

Company performances might get worse never mind better, making current valuations seem far to premature.

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