April 8, 2007
Fundamentally
A Caution Signal on Profits. A Red Light for Stocks?
By PAUL J. LIM
FOR weeks, Wall Street has been debating whether the economy is headed for a fall. That’s because investors “look to economic growth to see where corporate earnings might be headed,” says Sam Stovall, chief investment strategist at Standard & Poor’s.
But lost in this discussion seems to be an important fact: Corporate profit growth is already decelerating at a significant pace. And so, too, are earnings expectations for the coming year.
After increasing at a double-digit rate for several years, earnings for companies in the S.& P. 500-stock index are expected to grow by only 3.3 percent in the first quarter of 2007, according to Thomson Financial. This represents a huge drop in expectations, as Wall Street analysts at the start of this year were expecting a first-quarter growth rate of 8.7 percent.
The second quarter doesn’t look much stronger: analysts are predicting profit growth of just 3.5 percent.
And after soaring 16 percent last year, corporate earnings for the full year are expected to increase by only 6.3 percent. “Analysts have pretty much cut their forecasts in half for the year,” says Jack A. Ablin, chief investment officer at Harris Private Bank in Chicago.
Certainly, a growth rate of 6.3 percent is nothing to sneeze at. In fact, Mike Thompson, managing director of global research at Thomson Financial, points out that this would be fairly close to the historical earnings growth rate of about 7 percent. And this rate of growth, he added, “is far more sustainable than the double-digit rates we’ve seen lately.”
The mere fact that profit growth is slowing isn’t necessarily a disastrous development for stocks.
For example, Mr. Stovall looked at past periods of slowing earnings growth from 1966 to 2000. He found that in 4 of the last 10 such periods, the S.& P. 500 lost value. But this means that in a majority of cases, stock prices still managed to climb in the face of slowing profits. In fact, the average gain for the S.& P. 500 during these slowing periods was a respectable 7 percent.
Still, the pace of earnings growth is an important variable for investors to consider. Many market strategists believe that earnings have a bigger influence on the stock market than the overall economy does.
Mr. Ablin put it this way: “If you told investors that the economy would grow by only 1 percent but profits would continue to grow at a double-digit pace, you’d find the market would continue to climb higher.”
What’s important is not just the rate of earnings growth, but also the underlying trends. When earnings growth is low but on the upswing, it’s often a good time to invest, said Tim Hayes, chief investment strategist at Ned Davis Research in Venice, Fla. That’s because investors are anticipating better times to come.
But periods when the earnings growth is high but falling tend to be challenging for the market, Mr. Hayes said.
It’s during these periods, he said, that “the market begins to question the sustainability of earnings growth.” And “the market becomes vulnerable to disappointments,” he added.
Despite the swoon in stock prices in late February, the markets haven’t come close to pricing in the coming earnings slowdown, in the view of Richard Bernstein, chief investment strategist at Merrill Lynch.
“What’s happening now is an odd situation where earnings growth looks like it’s slowing, but people are hesitant to make that bet because every time they’ve made that bet in the recent past, earnings have surprised to the upside,” Mr. Bernstein said.
For the last 15 of the last 16 quarters, analysts’ estimates for earnings growth have turned out to be too pessimistic. And Mr. Thompson added that analysts have recently underestimated actual earnings by around 3 percent.
“It’s now almost become a Pavlovian response,” Mr. Bernstein said, where investors immediately bet on better-than-expected earnings once analysts post their forecasts.
But is it safe to keep counting on analysts being too pessimistic? These misses tend to come in distinct cycles. From 2001 to 2003, for example, analysts consistently overestimated the earnings capacity of corporations. Before that, in 2000, they routinely underestimated profits. And in the late ’90s, their outlooks were again too rosy.
To be fair, at least a couple of forces could help earnings exceed expectations this time around. For starters, corporations are continuing to buy back stock at a record pace, in effect reducing the supply of shares on the market. This could improve earnings per share without bolstering the profits themselves.
Furthermore, the dollar continues to weaken, Mr. Bernstein said. And this could improve the profit outlook of American companies that do business abroad.
Still, it’s important to consider which earnings are slowing the most.
For example, at the start of the year, earnings in the energy sector were predicted to grow 13 percent for the first quarter. Now, they’re expected to fall by 3 percent. At the same time, profits for consumer-discretionary companies — which make goods that households tend to buy when times are flush, like cars — are predicted to drop 10 percent in the first quarter.
Mr. Thompson argues that the expected drop in consumer-discretionary earnings is largely attributable to weakness in the home-building sector as well as at the Ford Motor Company.
NEVERTHELESS, it’s clear that the sectors driving these downward revisions are predominantly economically driven ones like industrials, basic materials and technology.
In fact, technology earnings, which at the start of the year were expected to grow 17 percent in the first quarter and 20 percent in the second, are now forecast to increase by just 10 percent and 12 percent, respectively.
What does it all mean? Perhaps investors who have been studying the economy to gauge the outlook for future earnings growth should look in the opposite direction. The already slowing profit picture indicates that the economy has been weak for some time and may be weaker than some people have assumed.
And if that’s the case, investors may start to question what exactly is propping up the current bull market.
Paul J. Lim is a financial writer at U.S. News & World Report. E-mail: fund@nytimes.com.
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