The Frankenstein Economy?

Earnings season is in full swing, with over 700 companies geared up to report this week. This will be the key market driver, with little other than Leading Economic Indicators and Jobless Claims on the calendar this week.

Overall, we have seen marked improvements in profitability, and some slight improvement in top line revenue growth. We agree with First Call’s earnings observation: “Despite our euphoria over the current earnings patterns, we continue to be concerned that investors may extrapolate this earnings improvement into 1H04 and raise estimates to levels that may not be achievable.”

Thus, the two questions which should be on investors minds are: 1) How much of the good news is already reflected in stock prices? 2) What are the earnings reports and management’s comments telling us about the ongoing improvement in the economy’s health?

In our view, the good news is already reflected in the heady run up of lower quality, profitless issues – especially 2nd tier technology and telecom firms. On the other hand, the impact of economic improvements and the massive stimulus package may not yet be fully reflected in the stock prices of the higher quality, dividend-paying companies.

That dichotomy gives us pause. We fear that we may be witnessing the “Frankenstein Economy.” In the classic horror film, the deceased body has been reanimated through the application of massive doses of electricity. Similarly, we have jolted the economy back to life via historical levels of tax cuts, interest rate cuts, increased monetary supply, devalued currency, and deficit spending.

As we move away from the initial stimulus, we are starting to see its effects wane. The 0.2% drop in LEI may be reflecting that. Is this the beginnings of a new business cycle, or is it merely the temporary effects of stimulus? If it is the latter, we do not know what sort of problems this will engender if the body slumps back onto the slab.

Can Greenspan & Co. pull the economic levers just the right way to defeat the normal business cycle, bypassing the refractory period? What are the side effects if he cannot?

We hope the economy continues to improve on a self-sustaining basis. The nightmare scenario is that the stimulus has merely temporarily “reanimated” the economy via incredible levels of stimulus — most especially, since the Iraq war started. Recent data points to a recovery that is entering a crucial phase. We believe the next two quarters will reveal whether or not the patient has been reanimated or not.

UPDATE
For an amusing (and less serious) precursor to this piece, See the “Fronkensteen Economy.”