Don't expect earnings surprises to last

(breakingviews.com) -- If the key to happiness is low expectations, then stock investors must be over the moon.

Over a third of the S&P 500 index constituents have reported second-quarter earnings. Even though profits are down about a third from a year earlier, more than three-quarters of the firms have beaten analysts' expectations, according to Thomson Reuters. That's on track to be the highest ratio ever. But investors shouldn't get ahead of themselves.

The idea that companies are handling tough times better than feared no doubt has helped lift the S&P 500 (SPX) by more than 20% since the end of March. Yet the foundations of a sustainable recovery look shaky.

That's because non-financial companies have managed to improve earnings only by sharply cutting costs. Manufacturing and trade inventories have also been falling since the start of the year, according to the Department of Commerce.

These relatively quick and easy fixes will be harder to replicate with every quarter that passes. If companies cut costs too far, eventually nobody is there to answer the phone or assemble the sandwich. Inventories eventually reach the minimum levels required to do business.

What companies eventually need is revenue growth, which is closely tied to economic growth. This is where the news is less good. Perhaps not surprisingly, the S&P 500 companies that have reported so far saw revenues shrink an average 2% from the second quarter last year.

The rise in spending by American consumers and businesses that might boost revenues doesn't look imminent. Companies are planning further cutbacks in both employees and capital expenditure, according to a recent National Association of Business Economics survey. That probably means lower sales of everything from clothes to power plants.

Furthermore, consumers and firms are squirreling away cash, repairing their balance sheets. Even when spending does turn up, it'll probably happen slowly.

Combined with somewhat more optimistic forecasts from analysts, all this suggests expectations will be much tougher to beat in the next quarter. Unless businesses and consumers open their pocketbooks soon, the rally in stocks could easily falter.