Thursday, February 1, 2007

Will Profits Snap Their Hot Streak?

News Analysis
February 1, 2007

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Will Profits Snap Their Hot Streak?

S&P 500 companies have posted 18 consecutive quarters of double-digit earnings growth. But the string might end this quarter, some analysts say

Corporate profits are coming off a tremendous run. Since 2002, the Standard & Poor's 500-stock index has chalked up 18 consecutive quarters of double-digit earnings growth (see, 10/23/06, "So Far, So Good for Earnings"). With companies so far reporting a lackluster fourth quarter, the current earnings period could spell an end to profits' impressive streak.

If December-quarter earnings season ended today, the double-digit tear would already be over. As of Jan. 31, with 57% of results in, S&P 500 companies have posted slightly lower-than-expected earnings growth of 8.1%, according to S&P. "There would need to be several major surprises to put it over 10%," says Howard Silverblatt, S&P's senior index analyst.

Meanwhile, stocks have nudged higher amid lower profit forecasts and economic data suggesting the Federal Reserve won't change interest rates any time soon. Since Alcoa (AA) unofficially kicked off earnings season after the Jan. 9 closing bell, the Dow Jones industrial average has risen 1.7%, to post a new all-time closing high of 12,621.69 on Jan. 31. Over the same time, the S&P 500 has added 1.9%, to 1,438.24, while the tech-heavy Nasdaq composite is up 0.8%, to 2,463.93.

"Very Ho-Hum"

Wall Street still awaits earnings reports from bellwethers such as Exxon Mobil (XOM), Wal-Mart (WMT), and Cisco (CSCO). Some market pros worry that a number of companies have issued weaker forecasts for the quarter and year ahead. Whether the S&P 500 snaps its streak this earnings season or in a later quarter, profit growth is widely projected to fall from its recent heights in 2007.

Companies are also losing their edge when it comes to expectations. While fourth-quarter earnings are positive, with 63.5% of the S&P 500 beating analyst estimates so far, that percentage is below historical levels, according to Silverblatt. Prominent downside surprises have included Advanced Micro Devices (AMD) and Alcatel-Lucent (ALU).

"I would characterize this earnings season as very ho-hum," says Ashwani Kaul, chief market strategist at Reuters Estimates. "Right now, I think it's 50-50 whether we will hit double digits for the quarter."

Strength in Finance

The streak could hinge on the energy sector, Kaul says. ExxonMobil announces quarterly results Feb. 1, with rival Chevron (CVX) issuing its earnings report the next day. The sector's earnings growth has slowed from record highs amid lower oil prices, but energy shares are still on track to account for 13.2% of the S&P 500's earnings, despite representing just 9.6% of the index's market value, according to S&P.

One source of strength has been the financial sector (see, 1/22/07, "2007's Top Picks: Financial Services"). The mergers-and-acquisitions boom has boosted brokerages and banks such as Goldman Sachs (GS) and Merrill Lynch (MER) despite an inverted yield curve—the condition when short-term rates are higher than long-term rates that's thought by some observers to prefigure recession. Asset managers such as Franklin Resources (BEN) have benefited from inflows (see, 1/31/07, "Asset Management: Not Tapped Out Yet").

The financial sector's share of S&P 500 earnings is 26.7%, the highest of any sector, notes Ed Yardeni, chief investment strategist at Oak Associates. Financial issues account for 22.2% of the index's market capitalization. "While investors have been getting whiplashed in energy, financials have been steady winners," Yardeni said in a Jan. 31 note to clients. "Financials have always sold at a discount to the market because they've tended to blow up every four years or so. They aren't blowing up anymore," he added.

Tech Warnings

Technology, however, has been more of a mixed bag (see, 1/16/07, "Tech Earnings: The Highs and the Lows"). About 72% of the S&P 500's information-technology companies have beaten analyst estimates, according to S&P. Among them is Wall Street darling Apple (AAPL), along with IBM (IBM), Intel (INTC), Microsoft (MSFT), Google (GOOG), Sun Microsystems (SUNW), and Yahoo! (YHOO). AMD, SanDisk (SNDK), and others have disappointed the Street.

However, tech companies and others have been issuing weaker outlooks for 2007, which could signal trouble ahead. The proportion of companies guiding higher has fallen to 7%, below recent levels, while the proportion of those guiding lower has climbed to 10% after trending downward in previous quarters, according to Barry Ritholtz, chief market strategist at Ritholtz Research & Analytics.

"There's not a lot of bad news in the earnings reports," Ritholtz says. "The only thing we've seen that's just a little disappointing has been that the guidance is weaker than you would've hoped for."

Some market pros expect slimmer profit increases this year to weigh on the stock market. Joe Battipaglia, chief investment officer at Ryan Beck, predicts full-year earnings growth of 8%, which he says could lead to a market correction of 5% to 10%. "The profit picture is more muted than it had been," Battipaglia explains. "The market will have to adjust to that, which means it probably won't have the same get-up-and-go that it had last year in the second half."

Looking Ahead

However, others say fears of earnings slowdowns causing a pullback may be overdone, noting that moderating growth in corporate profits has been widely anticipated. "We would take advantage of current earnings misperceptions and buy into the integrated energy and chip stocks, which have been weak of late, while maintaining some caution still on the banks and materials names," wrote Tobias Levkovich, chief U.S. equity strategist at Citigroup (C), in a Jan. 26 report.

Of course, the current earnings season is a long way from over, and some big upside surprises may yet put profit growth back on the double-digit track. Either way, investors will soon consider the fourth quarter ancient history—and turn their attention to the quarters to come.

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