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Surprise rally is far from illogical

July 25, 2009|TOM PETRUNO

Wall Street was back in panic mode this week. But this is the kind of panic that adds to your net worth instead of annihilating it.

Buoyed by another batch of surprisingly good corporate earnings reports, investors drove stock prices sharply higher for a second straight week.

Buyers wanted into the game while potential sellers were reluctant to part with their shares. That's the simple setup for a powerful rally.

In just two weeks the Standard & Poor's 500 index has surged 11.4%. That's more than the net progress it made in all of 2005, the middle year of the last bull market.

A jump like that does another measurable bit of repair work on investor portfolios that have been decimated since the market peaked in late 2007.

Now, here's what passes for a spectacular earnings report these days: 3M Co., which makes more than 50,000 products for sale worldwide, on Thursday said its second-quarter profit tumbled 17% from a year earlier, to $783 million.

Yes, that's a big decline that screams "recession!" Yet Wall Street was expecting much worse -- a drop of about 32%.

The market's fast verdict was that 3M deserved a better stock price for preserving more of its bottom line. The shares jumped $4.76, or 7.4%, to $69.43 for the day and held on to all but a penny of that gain on Friday.

Bearish investors will say that a "not-so-bad" earnings report isn't the same as a genuinely good report. Ditto for all the not-so-bad economic data of recent months, most of which have shown the economy still contracting, just not at the same blistering pace of last winter.

Michael Vogelzang, who oversees $1.5 billion as president of Boston money manager Boston Advisors, says clients who are disbelieving of the market's rebound have the same basic line about it: "They say, 'This doesn't make any sense' " in the context of the awful economy.

But that's misunderstanding what motivates people to take a flier on stocks. They're betting on the future, not the past. Every not-so-bad report leaves some investors wondering how much better the next quarter might look, and the quarter after that.

You may believe the buyers are delusional, but they're reacting to hard numbers.

Three weeks into this earnings-reporting season, 184 companies in the S&P 500 index have issued their second-quarter results. Of those firms, 77% have beaten analyst estimates, according to earnings tracker Thomson Reuters. That's far above the quarterly average of 61% back to 1994, Thomson says.

What's more, S&P 500 company earnings so far are exceeding expectations by nearly 19%, a record amount.

Obviously, analysts set the earnings bar too low. But they usually do.

What's impressing investors is that, considering the dive in revenue that most companies experienced in the second quarter, earnings weren't substantially worse.

3M, for example, suffered a 15% drop in sales last quarter, to $5.7 billion.

"At this pace of revenue decline you'd expect to see three to four times the size of the profit declines that we've had," said Steven Wieting, head of economic and market analysis at Citigroup Global Markets in New York.

To explain why earnings haven't collapsed, look no further than the ranks of the unemployed. Drastic cost-cutting, including severe layoffs, has significantly offset the loss of sales at many firms.

"What is particularly remarkable about the current downturn is how quickly companies adjusted costs," said Carmine Grigoli, chief investment strategist at Mizuho Securities in New York.

That's of no comfort to the jobless. But the success many companies have had in protecting earnings from a steeper drop could give managers more confidence that they've done enough ax-wielding.

If companies expect even a slight rise in sales later in the year or in 2010, they may figure that the earnings leverage from that upturn could be huge.

Panicked stock buyers are thinking the same thing about leverage. "I think that's what's being priced in now," Vogelzang said.

The much broader question is whether the global recession really is ending or just setting up for another leg down.

Stock markets worldwide have been voting in favor of the idea that the bottom has been reached in the economy. They could be wrong, of course.

But given the already horrendous declines in key sectors of the economy, including housing, autos and business inventories, a natural point of stabilization is likely to be reached sooner than later, Wieting said.

"In the real economy there's not much left to recess," he said.

Optimists also point to the continuing thaw of the credit markets, even as more troubles loom. Investors know that many banks will face higher loan losses, especially in commercial real estate. The potential failure of small-business lender CIT Group is a near-term threat.

Still, the fear of another systemic breakdown of the financial system has receded, thanks in no small part to the trillions of dollars of government support for lenders.

Certainly, for investors who have no faith in an economic recovery, or who expect another financial crisis soon, the stock market's surprise summer rally must look like a great opportunity to exit.

But the hunger for stocks over the last two weeks should at least make sellers today ask what sellers at the market bottom in March should have asked: "Could the buyers know something I don't?"

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tom.petruno@latimes.com

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