Why sales matter more than profits

(Money Magazine) -- Whether you're speaking the language of Wall Street or just plain English, you know the "bottom line" is what's supposed to matter most. And corporate America's bottom line, otherwise known as profit, is shaping up nicely.

After contracting for more than two years, earnings rebounded sharply at the end of 2009 and are expected to have grown about 57% in the first three months of this year. Already the talking heads on CNBC are shouting "Dow 12,000!"

But looking only at earnings to gauge the strength of the economic recovery is viewing the world through very rose-colored glasses.

Forget that profits can always be touched up to make things appear brighter than they really are. Earnings are looking good today not because the economy is sizzling (at least not yet), but because companies cut costs so aggressively in the downturn.

But while businesses can boost their bottom lines by slashing expenses just as you can by cutting those Starbucks runs, at some point the trick loses its buzz.

For an earnings recovery to be truly sustainable, companies will have to find ways to boost sales meaningfully over time. In the fourth quarter they grew by 3.5%. First-quarter sales should show a much nicer pop of 11%.

That's a solid gain, but the comparison is with the deeply depressed base of a year ago, when stock prices and consumer psyches bottomed out. And the rise is less than a quarter of the expected jump in profits.

So what is the sales outlook telling you? For starters, it says that even though the recession is over, the recovery isn't as rollicking as the earnings outlook would lead you to believe. So if the near term has you extremely bullish, the longer term may disappoint you.

At the same time, you can use sales figures to assess which segments of the economy are healed -- and which have a way to go.

Ned Davis Research, an investment advisory firm in Venice, Fla., recently found that revenue is still down around 14% for the S&P 500 companies from their peak levels before the downturn.

But among health care firms and consumer staples companies -- outfits that make things like toothpaste and soap -- sales have recovered. However, those sectors haven't risen nearly as much as financial stocks this year because bank profits are expected to zoom.

Take off your rose-colored glasses, though, and you'll see that financial sector sales are expected to rise just 2.5% in 2010. By contrast, health care and consumer staples sales are seen climbing around 15%, according to S&P estimates.

James Paulsen, chief investment strategist for Wells Capital Management, says he's confident that "top line" sales growth is on the mend everywhere, including in economically sensitive groups like financials. But he argues that sales will really pick up only after there's been an improvement in hiring, possibly later this year.

Until that happens, pay attention to the top line. It offers a much clearer view of the world.