Gauging the Health of the Economy Using Third Quarter Earnings

When you look at performance over the past two months, it's obvious how extremely erratic this market has been. For example, the Dow Jones Industrial Average dropped to 10,500, yet rose to 11,600 just one week later. That's more than a 10% gain - in just one week! All this movement makes it extremely difficult for investors to judge the market's direction - not an ordinarily easy task, anyway. However, third quarter earnings reports indicate the direction specific sectors are headed in, plus the economy as a whole. Here are a few areas to be mindful of:

It is always important to block out the noise from both sides of the trading equation. Bulls will tell you to invest heavily in the market when it is rising and bears will tell you to sell your shares when the market is falling. Instead of paying attention to market chatter, pay attention to earnings. Third quarter earnings of retailers and banks tell a lot about the financial health of the American consumer. For example, have companies been able to hit their numbers after many of them have guided down to lower expectations? If not, this may indicate another economic downturn.

There has been much talk about the nearly $2 trillion in cash that companies are holding on their balance sheets. Were some of this cash to be used in the form of increased capital expenditures and payroll spending, it would signal that companies are investing in the long-term growth of their businesses and it could drive the market higher. This is because businesses typically make investments in human and financial capital when they believe it will pay off. In other words, they'll invest when they believe consumers will buy their goods or services. If company management feels confident about this, that confidence will spill over to and influence investors to buy instead of sell.

Many investors make the mistake of looking at the profitability of a company without paying attention to where those profits are coming from. Investors need to place more of a priority on revenue growth since it typically represents increased sales, which demonstrates healthy demand for a product. In fact, companies can hide declining sales by slashing spending, for example, as this will inflate profits and make a company look more prosperous than it really is. Spending cuts can give a company a temporary rise in net profits. However, that rise will quickly vanish after a quarter or two. Remember, top line growth is a better indicator of financial health than bottom line growth.

Third quarter earnings provide insight on the environment that companies are operating in for the rest of the year. It will be influenced not only by the numbers, but also by investor confidence, which is a fragile thing and highly dependent on what companies say. A series of good reports and optimistic outlooks extend the current rally even further, while reports of failing earnings estimates could revert it. By paying attention to earnings, watching the balance sheets, and studying income statements, investors can better determine where individual companies and the market as a whole are headed.