A Great Start to Earnings Season, but... (Ahead of the Curve)

Published Oct. 9, 2009 at 4:00 a.m.

Here comes another earnings season, and it's already started out with something of bang...Each quarter Alcoa (AA) is always the first to announce earnings, and its report after the close on Wednesday was spectacular -- earnings were more than twice what was expected.

Alcoa's top line was a positive surprise, too, with revenues beating expectations. If Alcoa is a bellwether for the whole Standard & Poor’s 500, then that could be very significant. Last quarter the average company beat earnings expectations by about 15%, the biggest upside surprise in more than two years. But the average disappointed on the top line, with revenues coming in 2% below expectations.

So the story was that companies were able to generate net income by cost-cutting -- their businesses weren't really fundamentally expanding. If they were, we'd see top-line growth. Maybe, with Alcoa's surprise, we are now.

Yet there's something nagging at me about this. While I believe that we saw a durable bottom for stocks in March, I nevertheless think the fantastic, nearly-uninterrupted rally we've had since then has been too much, too fast. As I wrote here a month ago, I think we might be in for a correction as investors "sell on the news" -- that is, cash in when all the big earnings surprises like Alcoa's come in, because it was the expectation of those surprises that caused the big rally in the first place.

Investors didn't exactly sell Alcoa on the news in Thursday's trading. The stock rose 1.1% on the day -- but that's not much given the apparent magnitude of the surprise. And Alcoa closed far from its highs of the day, achieved in a fit of exuberance right at the opening, with the stock 6.4% higher. Ouch, if you bought the opening...That's what happens when you "buy on the news" instead of selling.

There's another thing that's a little worrisome...Maybe Alcoa's big surprise isn't going to generalize to other stocks. After all, Alcoa's earnings and revenues are driven by commodity prices -- and commodity prices have been on an inflationary rebound led by gold surging to new all-time highs above $1,050 an ounce. What about all the hundreds of companies who don’t have that wind at their backs?

It could be that many companies, even if their earnings show sequential quarter-over-quarter improvement, nevertheless won't generate the kind of upside surprise that can sustain continued upward momentum in stock prices. After all, consensus forward earnings expectations for the S&P 500 have risen by more than 8% over the last quarter. That's more than they typically rise over an entire year, compressed in a single quarter. So the S&P 500 companies will have to jump a very high hurdle to generate an upside surprise.

Gold making new all-time highs raises other difficult issues as well. I believe it's a strong indicator of future inflation, and inflation is a very dangerous thing. Sure, after the deflation we've experienced during the recession and credit crisis, a little inflation is just the medicine we need. It's a good thing. But a little bit of that medicine is all we need. And with gold at new highs, that means we're going to get a lot of medicine, and not a little.

This is something I've been writing about here for a long time, most recently two weeks ago when gold broke through $1,000. Believe me on this -- don't make the mistake of thinking that serious inflation can't happen. If you believe that, then you're probably too young to remember the 1960s, 1970s and early 1980s when, at the worst of it, this country experienced inflation as high as 14.5%.

The gold price perfectly predicted that inflation. And now at new highs, it's predicting serious inflation again. You can do the math for yourself, to determine gold's track record as an inflation predictor. But let me save you the trouble. If you look at the times when the gold price has risen -- about two thirds of the time, inflation is higher a year after. Then look at the times when the gold price has fallen -- about three-quarters of the time, inflation is lower a year later.

With gold at all-time highs, that's more than merely having "risen." That's a new world's record. And it's telling you something...When the inflation of the 1960s and 1970s got started, gold was at about $40. By the end of it in 1980, gold had gotten to $850 -- making all-time highs over and over and over again on the way.

Right now, in the short term, gold is giving us good news. Again, the inflation it foretells is better than the crushing deflation we started to experience a year ago, which threatened to replay a similar deflation that ushered in the Great Depression.

And if gold goes no higher than it is now, the inflation we'll get in the coming years won't be anywhere near as bad as the 1960s and 1970s. This is the Fed's hope -- to keep interest rates super-low for what it calls "an extended period," so that a little inflation will grease the gears of commerce and get people borrowing, lending and spending again. Then the Fed will raise rates to bring inflation back into line before it's too late.

My problem with this is that I am convinced that the world is in too chaotic a state right now to permit the Fed the luxury of that kind of pinpoint control. To avoid any risk of slipping into deflation, the Fed will keep rates too low for too long. Then when its sees inflation running higher than it expected, it will be too late.

What will the Fed do then?

At first, it will hesitate -- because it won't want to risk another recession after the whopper we just had. But as it hesitates, inflation will mount. Then it will have no choice -- to prevent hyper-inflation, it will have to bite the bullet and cause a recession.

What I'm saying here is a strange mixture of short-term and long-term forecasting. Sorry if it confuses you -- let me try to be as clear as I can. In the short-term I think stocks are overbought and due for a correction. It could start right now, if earnings season is anything less than stellar. When that correction sets in and runs its course, there will be a buying opportunity, because my inflation nightmare will take a year or more to play out. We'll see it at work in inflation-sensitive markets like gold, but nowhere else.

But in the long term, say a year or more out, the inflationary chickens will come home to roost. Then we'll have to worry about a lot more than a mere correction.

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