While Alcoa is only one company, the firm is symbolic of the U.S. manufacturing sector as a whole and it’s profits are directly affected by the prices of input commodities, primarily petroleum products and aluminum ore.  Below is a 1-year chart of the S&P 500, annotated according to AA earnings results vs. estimates. (Click chart to expand in a new window)

As shown above, the S&P 500 has rallied from the announcement of AA earnings following each of the past three quarterly announcements. The once discarded industrial giant has found new importance over the past year in financial markets as it foreshadows the industrial earning power of the U.S. The recent two quarterly results beat estimates, while the Q1 2009 results were very near the street’s consensus at the end of a period wrought with massive earnings let downs. All in all we see the first three AA quarterly results of 2009 as better than expected.

Naturally, Alcoa can’t dictate the earnings of an entire economy, but the two factors causing the firm to miss earnings will be applied to bottom lines as earnings season picks up in the following weeks. These factors were higher energy and aluminum ore costs combined a weaker U.S. Dollar. The macro economic message heard on Wall Street highlights real revenue destruction from a weaker domestic currency and the negative cost effects of higher oil.

The following two charts show the trend of these two factors of production below in the form of the USD index and the WTI Continuous contract.

Referring to the charts, the cost of petroleum based inputs to production and the devaluing of the U.S. dollar during the months of October to December 2009 are both evident. Immediately, traders and investors have begun applying heavier weights to these parameters when running their earnings models. Will this trend be the thorn in the side of earnings to bring the first season of the recovery where earnings miss more than beat estimates?

In our opinion the dollar has held it’s ground fairly well over the past month and may see a short term appreciation on interest rate concerns, while we view crude oil as overbought and due for a pullback. We follow the Moving Average Convergence Divergence technical series, as it has been highly predictive of price cycles in the many securities, mainly crude oil, over the course of the recovery, and see crude oil particularly overbought with respect to this statistic.

Whether earnings season is a make or a break for stocks relies on more than the results of just one firm, yet the manufacturing recovery story has remained the golden goose of 2009 and will not benefit from the implications derived from a negative AA earnings card.

Disclosure:

Currently we are short Crude Oil (DTO), short Consumer Services (SCC), and short the S&P 500 Index (SDS).

(By Clicking on the DS Portfolio tab in the navigation bar above, readers can follow the current portfolio held by Diamond Slice partners in real time.)

The consumption of manufactured goods represented 1.59%of the revised 2.2% U.S. GDP growth in Q3 2009 and thus remains the center point of the economic recovery as we have known it thus far. The growth indicative ISM report booned U.S. markets in the first 2010 trading session, as the seemingly unbeatable 60.3 November New Orders component was crushed by a 65.5 stat in December. New Orders are the single most telling economic reading of future conditions in Manufacturing, perhaps making this month’s strength unbeatable in January and ironically a curse on the effects of less positive results moving forward. Less discussed but also important, are increasingly slower deliver times that, if sustainable, should have positive effects on both transportation carriers’ top lines and jobs in the industry.

Standing on the shoulders of a massive rally to start 2010, it’s safe to say that the environment is still a wash of confusion. Inventory numbers from the report show that clients of manufacturers are becoming increasingly skeptical, where the Customers’ Inventories number at 35 perpetuated a nine month trend of contraction during one of the highest consumer demand months of the year. These results suggest that inventory rebuilding hasn’t occurred on par with headlines, and that instead the entire production chain has become extremely lean and risk averse. Should confidence return and consumers loosen their wallets, this would be a prime area of growth in the new year, but headwinds to such spending remain significant and could intensify. Partly frightening, is the component of higher input prices, continuing a six month trend of appreciation that is reflective of the commodity rally and U.S. Dollar weakness. While input prices have helped to raise the ISM headline number in recent months, U.S. Dollar strength will be discounted as having a negative effect on future reports.

Kicking the mud from our boots, let us shed the stats from our purview and think logically about the chances for economic success in the U.S. over the next year. 2010 estimates for U.S. GDP growth are floating in the mid 3% range, but where can we expect to find growth summing up to this handsome rate of expansion?

In the U.S. 24% of annual GDP dollars are rooted in manufactured goods, while the service industry brings in nearly twice that figure. In Q3 of 2009 we lost about 3% to our trade deficit, which should grow if consumers spend more, and the remaining 30% is split into one part domestic investment, two parts government expenditures. We can expect that the government isn’t going to muster much more growth in 2010, due to it’s bureaucratic inefficiencies and the Q3 2009 0.5% annual contributed GDP growth, despite $700 billion (5.3% x GDP) of stimulus.

For all intensive purposes we’re left with the manufacturing and service industries to get us most of the way to 3% growth. “We did it in 2003, so it’s just a matter of animal spirits… right?” Unfortunately, in our opinion, the game has changed significantly, making 2009 anything but 2003 . First, there is not an abundant supply of new homes, and the supply we have aren’t being bought, so the big new houses of Super Sized Suburbia30 miles from town won’t have the same magnetic effects on consumption as were present in 2003-2006. Instead we’re seeing strength in existing home sales and less confident buildersrealizing that bigger isn’t better. Second, unemployment is expected to average 10% in 2010, according to Bloomberg economists, landing well above the worst case scenario for financial institutions outlined under the Stress Tests in April of 2009 and crippling to the financial strength of the government, as Washington continues to roll over benefits and pay to jobless individual. Third, the shadow inventory of homes, as described by Robert Shiller, will flood the market with more defaults as teaser rates reset higher, even as rates are low, while weakening bonds will inevitably send mortgage rates higher.

Some of the smartest guys in the room are beginning to make calls that hold viral ramifications for the economy. Robert Shiller is predicting higher rates of defaults in the prime mortgage category, while Bill Gross is liquidating most of his exposure to bonds, and still many see this scenario as a victory on il-applied grounds of historical market recoveries. Perhaps confident retailers and mid-chain distributors could lift inventory levels as consumers spend more of what they’ve saved, but there must be widespread consumer spending on services as well as goods, at magnitudes congruent with a boisterous labor market, for 3% GDP to become a reality. At minimal, do your homework before placing your bets on a recovery founded in manufacturing, and at best keep limber to capitalize on the self fulfilling prophecy that equity markets have become when sentiment changes yet again.