The Great Big Stock Market Disconnect

Great Big Stock Market DisconnectDon’t buy this stock market. It isn’t worth the risk. Relative to earnings, most stocks aren’t expensively priced—but there’s a reason for that. There just isn’t enough real economic growth in the marketplace. Some companies are doing well (as we’ve been highlighting), and I’d say buy great companies when they’re down on the stock market; but the trouble is that the market is trading right near its high.

A lot of companies reported solid earnings in the fourth quarter, and the stock market was happy about it. The problem is that revenues either came up short, or revenue outlooks weakened for 2013. The market always focuses on earnings, but the most important financial metric that’s worth betting on isn’t earnings—it’s revenues. This is especially the case in a slow-growth environment.

Cummins Inc. (NYSE/CMI) is a company I’ve admired for a long time. It makes great engines, and since 2005, the company has been a great wealth creator on the stock market. The stock just reported its fourth-quarter earnings results, and the story went like this: Cummins beat the Street on 2012 fourth-quarter revenues and earnings, but its guidance for 2013 fell short of consensus. So, the stock went up on the revenues and earnings results.

However, the problem is that the company’s earnings only beat consensus in that they dropped less than the Street was expecting; fourth-quarter revenues fell 13% to $4.3 billion, also dropping less than consensus. To me, this isn’t good news at all, yet the stock went up on the announcement. The company’s stock chart is below:

CMI Cummins Inc stock market chart

Chart courtesy of www.StockCharts.com

This is the great big disconnect in the stock market today. Stocks are going up on better-than-expected results, but in a lot of cases, there isn’t any real economic growth at all! The only reason I can think of why many stocks are going up on mediocre news is because most are trading below their historical valuations.

Corporations have done an outstanding job of maintaining their earnings throughout the last recession and in the current slow growth environment. Large corporations are especially good at this through cost control. But what we need to see is meaningful top-line growth, and we’re not getting it consistently from industry. This is the reason why I’m not bullish on the stock market and why I wouldn’t be a buyer right now.

Cummins is a solid company with a great history. The stock is trading near its all-time high, even though its fourth quarter was terrible. (See “Stock Market Investor Sentiment Drops Again…Why?”) According to the company, its 2012 total revenues fell four percent to $17.3 billion, with North American sales up nine percent, offset by a 15% drop in international markets. The company noted that sales in Brazil, China, and Europe were particularly weak. Fourth-quarter engine sales were down 18% to $2.5 billion; component sales were down 14% to $939 million; power generation sales were down 17% to $765 million; but distribution sales were up nine percent to $907 million (but that’s only due to a recent acquisition). (Source: Cummins Inc. fourth quarter and 2012 financial results.) All this, and the position is trading right near its all-time record high on the stock market.

Unless revenue growth materializes next earnings season, the stock market is dead. Because corporations are so lean now, revenue growth will translate straight to earnings, and that’s what this stock market needs to stay afloat.

After the dismal fourth-quarter gross domestic product (GDP) numbers, the stock market basically ignored the news, figuring it was a one-off aberration due to military spending cuts. So, how is the first quarter of 2013 suddenly going to be so magical? It isn’t. And stock market investors need to be very cautious going forward.

Fourth-quarter and full-year 2012 revenues were mediocre, and earnings came in flat. Some companies are doing well, both operationally and on the stock market. A lot of other companies aren’t doing so great, but their share prices are up anyway. It’s the classic sign that the bull market has run its course.

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