Profitless Recovery' Fears to Limit Gains
Sunday April 14, 8:59 am Eastern Time
biz.yahoo.com
By Chelsea Emery
NEW YORK (Reuters) - The U.S. economy is on the mend and economists are rushing to raise their year-end growth forecasts. Why, then, are stocks mired? The answer lies in a new catch phrase sweeping Wall Street that sums up investor fears: A profitless recovery.
This oxymoronic phrase illustrates a jump in economic growth but a slow-by-comparison recovery in corporate earnings. The paradox has emerged as businesses hold back from spending on new equipment and as reports of business accounting irregularities have made Corporate America cautious about financial forecasts.
``There's a there's a fear of a profitless recovery, where the economy is improving, but profits aren't improving commensurately,'' said Stephen Massocca, head of trading for Pacific Growth Equities, a San Francisco-based investment bank. ``After the Enron scandals, management and their auditing firms are going to be more conservative.''
That will keep profits and sales forecasts moderate at a time Wall Street wants to see a strong profit rebound, and will limit stock gains, fund managers said.
The downbeat outlook counters earlier optimism that profits would soar throughout 2002 as lower interest rates, tax cuts and other measures jump-started the economy. Those factors surely helped, but unforeseen factors have come into play that limit stock gains, investors said.
``There's still too much capacity on the industrial side -- we were overbuilt and we're still deflating a big tech bubble,'' said Crit Thomas. ``Companies have already cut back spending, but they're not able to pass on any price increases to the customer.'' That will limit earnings growth, he said.
To be sure, there are some bright spots. Specialty retailers, restaurants and consumer staples companies are expected to post steadily growing profits because they rely on sales to individuals instead of Corporate America. But technology and telecommunications stocks will likely slump or be flat through the end of the year, fund managers said.
``Technology industries are tied to capital goods and there's no traction in that industry. Large enterprises aren't spending,'' said Bill Fries, a fund manager at Thornburg Investment Management, which oversees $5 billion. ``We're looking to businesses that are reliant on the consumer, from housing to retailing to foods, to supermarkets.''
Specifically, he said, his fund has added shares of cereal giant General Mills Inc. (NYSE:GIS - news).
Consumer spending supports about two-thirds of the U.S. economy.
Just take a look at Wall Street trading to see the recent shift in investor sentiment. The technology-heavy Nasdaq composite index (^IXIC - news) has sunk 10.5 percent this year, while the blue-chip Dow Jones industrial average (^DJI - news) has gained 1.9 percent.
PROFIT VIEW, OIL WORRIES
Earnings growth is present, but slow. Profits for companies in the Standard & Poor's 500 index (^SPX - news) are expected to fall 9.7 percent in the first quarter and rise a mere 2.8 percent in the second quarter, after taking some accounting changes into account, according to market research firm Thomson Financial/First Call.
For the year, profits are expected to rise between 3 and 6 percent, a weak showing after growth averaged 8.9 percent in the 1990s.
At the same time, S&P 500 companies are selling for a forward price-to-earnings ratio of about 21.8, higher than the historical average of about 15 to 17 percent, according to First Call. This ratio suggests that earnings are low compared with their stock price.
``Even with the tech sector removed, the market is still selling at 18 times earnings,'' said Thomas. ``It's not cheap. You want some upward earnings estimate revisions because it's earnings growth that gets you into a stock market recovery.''
Thomas said he's adding consumer staples such as cosmetics maker Estee Lauder Cos. (NYSE:EL - news) and Johnson Controls Inc. (NYSE:JCI - news), which makes automotive interiors and batteries, and paring tech firms including No. 1 software maker Microsoft Corp. (NasdaqNM:MSFT - news) and microchip maker Analog Devices Inc. (NYSE:ADI - news).
Even as the profit outlook seems dim, the economic outlook remains bright. Over the past month, private economists have almost doubled their projection for the U.S. economy's growth rate in the first quarter of this year -- to 4.5 percent from 2.6 percent -- according to the Blue Chip Economic Indicators consensus forecast.
COST CUTTING
To be sure, there is a Wall Street contingent that sees profits picking up. That's because companies cut employees and spending during last year's downturn, and, with an economic and business pickup, companies can use better productivity to rake in higher profits.
``There's a fear of a profitless recovery, but I don't see it as a potential,'' said Edward Hemmelgarn, president at Shaker Investments, which oversees $2.2 billion in Cleveland. ``Companies aren't going to increase their cost base, but there will be a pickup'' in sales. He said Microchip Technology Inc. (NasdaqNM:MCHP - news), for example, will see profit growth of 12 percent after improvements in gross margins.
But other managers counter that those spending cuts, which allow companies to increase margins, will reduce profits for other companies. The effects will ripple throughout Corporate America, especially tech firms.
``We could see further (stock) declines,'' said David Covas, who helps oversee $200 million for Oberweis Asset Management Inc. ``A return to a good rate of growth in profits will take longer than investors want. ''There's a question of when spending (in technology) is going to resume. At this point, it's a big risk.`` |
