March 17, 1998
Market Place: Companies Release Bad
News, Dow Just Goes Higher
By DAVID BARBOZA
EW YORK -- They call it the "confessional season," the period
when corporate America begins to warn Wall Street of the troubles
that lie ahead.
It is a time near the end of each quarter when
companies begin to leak out their bad news,
acknowledging slowing sales growth at
home, declining sales abroad, backlogs in
inventory and cyclical downturns in business.
Walt Disney, Nike, Intel and Compaq
Computer have all made dire first-quarter
forecasts, causing Wall Street stock analysts
to lower their estimates not just for these
companies but for the market over all. And
these analysts, according to First Call Inc.,
which tracks earnings estimates, now expect
profits at the nation's biggest companies to
grow less than 2 percent in the first quarter,
the slowest pace of the decade.
But attention is beginning to shift to the end
of the year. Will the coming slowdown be
just a blip or something more sustained?
Expectations for the second half of the year
remain quite robust from stock analysts, an
optimistic group by nature. By their count,
profits could show tremendous gains, up 17
percent in the fourth quarter.
Perhaps this explains why the stock market has rocketed to record highs
in the face of weakening results. But if these forecasts prove overly
optimistic, as some vocal market strategists suggest, investors may be in
for a sharp selloff in the latter part of the year.
"We think there's going to be a big squeeze on profits this year," said
Cynthia Latta, an economist at DRI/McGraw-Hill. "We're calling it a big
turning-point year."
After six years of mostly double-digit profit gains, the case for a longer
lasting slowdown is growing. Labor costs are rising, companies are
grappling with the year 2000 problem, and the economic squeeze in Asia
is only beginning to take its toll on American business. And after years of
restructuring and productivity improvements, companies appear to be
running out of ways to expand their profit margins.
Even the rosy stock analysts now accept that these factors have
conspired against companies early this year. First Call said that estimates
have been "falling like a stone" in recent weeks. IBES International Inc.,
another earnings watcher, said that estimates suffered the largest
downward revision last month in more than five years. Since Jan. 9,
estimates of first-quarter earnings growth have plummeted from 10
percent for the stocks in the Standard & Poor's 500 to 2 percent, the
lowest since 1991.
"We haven't seen anything like this since the recession of 1990," said
James E. Glassman, a senior economist at Chase Securities. "Throughout
the 90's we've been spoiled; we've only seen double-digit growth. So this
year could be sobering."
The same people racing to ratchet down their early year forecasts -- Wall
Street analysts -- are undaunted, forecasting a pickup in growth in the
second half that will lead to a 10 percent profit gain for the entire year.
But many economists and market strategists, who look at the big
economic forces instead of the prospects for individual companies, are
forecasting a more sizable slowdown, well below last year's 11 percent
growth rate.
The most optimistic among this group forecast 8 percent gains in
corporate profits; the less optimistic see gains of under 5 percent.
Corporate outlooks start with the economy, which grew at a 3.8 percent
clip last year -- the fastest pace in a decade. Blue-chip profits jumped
nearly three times as much.
So the question is: can blue-chip companies produce solid gains in the
eighth year of an economic cycle, and extend the longest continuous
period of profit growth on record? "I don't think so," Ms. Latta said.
The financial crisis in Asia -- seen last October as the prime threat to the
great bull market of the 1990s -- is a big factor, she says, but just one
among many.
For instance, the unemployment rate in the United States is 4.6 percent,
the lowest in 24 years, and as corporations struggle to find skilled
workers and retain their best employees, pressure mounts for higher
wages and more training programs. That means corporate costs could
rise and cut into earnings growth.
"We've got rising labor costs, rising fringe benefit costs and fierce
competition, and so margins are getting squeezed," Ms. Latta said.
"We're probably not going to see as much of a productivity gain this
year."
There are also currency problems emanating from a strong dollar and a
widening trade deficit because of cheaper imports from Asia. Eastman
Kodak, for instance, said that profits declined by 38 percent in the fourth
quarter, partly because of the strong dollar.
If the stock market's recent strength is any indication of investor
sentiment, many are dismissing the earnings warnings and cautionary tales,
perhaps because they've heard them so many times during the great bull
market of the '90s.
The Dow Jones industrial average -- after a record three consecutive
years with gains of 20 percent or more -- is up 10 percent this year. And
the S&P 500, a broader gauge, is up 11 percent.
Such gains have pushed stock valuations into record territory. The
price-to-earnings ratio on S&P 500 stocks has reached 26, meaning that
investors are paying about $26 for every $1 earned by those companies
in the last year.
Share prices generally reflect future earnings prospects instead of past
gains. But even on that basis, stocks are trading at 20 times future
earnings, at or near a historic high.
"The only way you can support these kinds of ratios is to see profit
margins expand," said Steven Leuthold, an analyst at the Leuthold Group
in Minneapolis. "And I don't think we're going to see that."
The threats to the market are several. Byron R. Wien, the United States
investment strategist at Morgan Stanley, Dean Witter and a long-time
bear, expects a big economic growth spurt will come in the second part
of the year, pushing up interest rates and knocking stocks for a loss.
Others, pointing to Asia's continuing economic woes, expect the economy
to go in the opposite direction.
"Those who think this is a one-quarter phenomenon in Asia are just not in
touch with reality," Leuthold said. "I've talked to a number of people in
Asia and they say that in the U.S. we're just not cognizant of the
devastation in Asia."
Of course, there are those, like Abby Joseph Cohen, the co-chairwoman
of the investment policy committee at Goldman, Sachs & Co., who
expect the slowdown in Asia to temper a robust economy in America and
eliminate the need for the Federal Reserve to raise interest rates, a
positive for stocks.
Profits may moderate, she says, but the U.S. economy is like a
"supertanker," not the fastest or flashiest ship on the sea, but because of a
well-balanced economy and well-managed companies, perhaps the
sturdiest.
To some strategists, the earnings numbers in recent years seem almost too
good to be true. Skeptics say that companies have managed their
earnings, through such things as special charges and mergers, to the point
where creative accounting can no longer help them out.
Barton Biggs, the erudite global strategist at Morgan Stanley, likens the
American stock market to the Titanic, and he has written repeatedly
about how companies distort their earnings through accounting sleight of
hand. "It is well-known that the S&P 500 sells at the highest valuations of
earnings in history," Biggs wrote recently. "But it is less well recognized
that the index's earnings are overstated.
"For example, a company may take care of a mistake with a one-time
writeoff, in which it also buries other expenses that are to come. In effect,
future earnings are enhanced."
James S. Chanos, president of Kynikos Associates, a New York firm
that specializes in betting on which stocks are poised to fall, agrees.
"Earnings quality has gone downhill," he said. "The longer the bull market
has lasted, the lower the quality of earnings companies have reported.
We're seeing companies play games in write-offs.
"Companies know they have to show bottom-line earnings growth,"
Chanos added. "So by hook or by crook they'll do it."
The S&P earnings game is becoming so difficult to understand -- in part
because of the recent changes in how companies report earnings -- that
Ms. Latta at DRI/McGraw-Hill says she does not trust her own firm's
projections for S&P 500 growth in 1998.
She does, however, trust her projections for earnings growth for all U.S.
corporations, as listed in statistics compiled by the Commerce
Department's Bureau of Economic Analysis. Those figures have steadily
fallen, from 16 percent in 1995 to about 8 percent in 1997, she said. Her
projection for 1998 is just 1.2 percent.
If earnings slow sharply, that could depress share prices, which have
vastly outpaced earnings growth since the 1980's.
Although earnings growth and share prices tend to rise equally over time,
they alternate leadership roles, according to a Federal Reserve study
released last year. And for a long stretch, since 1982, share prices have
been the leader, with an average annual stock gain of 12 percent,
compared with an average earnings gain of 8 percent.
"The implication is that we're in the next 15-year period, when earnings
will do better than the index," said Robert Farrell, a longtime strategist at
Merrill Lynch. "And if that's the case, we can't afford to have earnings
disappoint."
Still, shares of many companies are soaring. Even companies that have
warned of trouble ahead -- or had their earnings estimates slashed in the
last month -- have done well.
Disney and Intel, for instance, saw sharp declines after issuing earnings
warnings, but remain strong this year, with shares of each up 11 percent.
Sears, Roebuck warned of a 50 percent decline in first quarter profits
because of difficulty in its credit card business, but its shares are up 30
percent. A month ago, Nike warned of profit trouble, caused by sales
declines and inventory buildups in Asia and the United States. Still, shares
are up 15.5 percent.
A growing array of economists and market historians are baffled.
"It's like all news is good news," said Farrell of Merrill Lynch. I've spent
my life saying the market's right, but the sustainability of this is
questionable if earnings are going to disappoint beyond a quarter or two." |
