Dollars and Sense: Buckle up for a bumpy ride ahead

Earnings season. We’re deep into earnings season, and things are not looking great. Eight of the 30 stocks in the Dow Jones Industrial Average reported earnings this week, and they haven’t been terrible. In fact, most of them either hit or came close to hitting earnings estimates. It’s the revenue numbers, or the future guidance numbers, that are causing concern. McDonalds, for example, reported solid earnings, but said same-store sales had declined and that 2013 had been a challenging year. More examples: IBM said Wednesday earnings met expectations, revenue did not. United Technologies also beat earnings expectations but missed revenue projections. And Advanced Micro Devices said first-quarter revenue would not match previous guidance.

Why future guidance is important. Within limits, a company can manipulate its earnings number. If sales are slow, they can cut expenses and keep earnings the same. But they can only do that so long. During a recovery, analysts want to see company sales going up, and the company making investments in new products, sales, and marketing. We’re supposed to be in a recovery, and we’re just not seeing that to the extent lots of analysts think we should. So what are the consequences? Lots of analysts think this stock market is overvalued compared to earnings. Stock prices compared to historical earnings are well above historical averages now. Prices tend to revert to the mean over time, so either earnings have to go up, or stock prices have to come down. Maintaining earnings by cutting expenses alone, without seeing some revenue expansion, is not a recipe for future earnings growth. And that’s one reason stock prices have been drifting downward since the first of the year.

China. With all the economic news going on here in the United States—the budget deal, earnings season, and more—we’ve not been hearing much about the global economy in recent months. But China has been back in the news this week. Thursday reminded analysts how China remains a major factor for the U.S. economy. Stocks dropped sharply on Thursday when a key indicator for China’s manufacturing sector indicated the country’s manufacturing industries are contracting. Alec Young of Standard and Poor’s said about one-third of the S&P 500 companies’ revenue comes from overseas, and the largest and fastest growing foreign economy is China. Consensus projections have China’s GDP at about 7.5 percent in 2014, which is still well above most of the rest of the world, but that number represents a slowdown. China faces some serious problems ahead, including corruption and pollution, not to mention a credit bubble. The country is at a place in its development where it could experience not just a slowdown, but a serious disruption. The manufacturing number released this week, which showed not just a slowdown in growth but an actual contraction, really caught people’s attention.

The week ahead. Economic news was slow this week—apart from earnings reports—but next week promises plenty for analysts to chew on. The U.S. Commerce Department announces new home sales Monday. We get durable goods and consumer confidence reports Tuesday and the initial estimate of fourth-quarter GDP on Thursday. The markets will be watching all these reports closely this week. And, of course, they’ll be keeping an eye out for earnings surprises now that we are moving past the earnings season midpoint. So buckle up, because things are going to move fast.