Monday, March 5, 2007

Profits: A Silver Lining for Stocks?

News Article
March 5, 2007

BusinessWeek Logo

Profits: A Silver Lining for Stocks?

While major equity indexes have gone wobbly, corporate earnings have quietly posted another quarter of double-digit growth

One modestly upbeat statistic went mostly unnoticed during the past week's global equity gyrations. The Standard & Poor's 500 index appears poised—albeit just barely—to record a 19th consecutive quarter of double-digit earnings growth, trumping many forecasts to the contrary (see, 2/1/07, "Will Profits Snap Their Hot Streak?"). While corporate profits may post smaller gains going forward, the outlook isn't all gloomy for Wall Street.

Right now, investors will probably take all the good news they can get. On Mar. 2, the Dow Jones industrial average finished its worst week since March, 2003, while the S&P 500 capped off its biggest weekly decline since January, 2003. Downbeat economic reports, a plunge in Chinese equities, and concerns about a sharp rise in the Japanese yen all helped snap a market rally that had gone on nearly uninterrupted since mid-2006.

Fourth-quarter earnings, at least, may have defied skeptics. If the reporting season ended today, Corporate America squeaked out another quarter of double-digit earnings growth. With more than 92% of results in as of Mar. 2, S&P 500 companies have posted an average earnings increase of 10.05% for the period, according to S&P.

Down to Earth

The streak may be running down, but investors shouldn't necessarily worry. While analysts expect earnings growth to slow in the months ahead, a dramatic, 2001-style turnaround in U.S. corporations' bottom lines probably isn't in the cards. Stocks could still have upside surprises in store, providing opportunities for savvy investors, even in the current volatile market environment (see, 3/12/07, "What the Market Is Telling Us").

Ashwani Kaul, chief market strategist at Reuters Estimates, sees earnings growth dropping off sharply in the first three quarters of 2007, then returning to double digits in the fourth quarter. "Corporate profits are still going to grow, but they can't just keep growing at the astronomical levels they have been," Kaul explains. Wall Street might not punish stocks too severely for the slowdown, he adds, because earnings should remain high in absolute terms following their 19-quarter run.

In fact, investors might keep stock prices afloat in anticipation of a potential rebound for profits in 2008. A couple of quarters of single-digit earnings growth won't necessarily pose a big hurdle for further S&P 500 gains, observes Goldman Sachs (GS) strategist David Kostin, who cites an expected 11% growth rate next year. "We believe the market in 2007 will focus on the prospect of accelerating earnings growth in 2008," Kostin says in a Feb. 20 note.

Further Volatility Ahead?

Meanwhile, the market may have already factored a slowing economy into stock prices. The long-term earnings growth expectations embedded in large-cap U.S. stocks imply potential GDP growth of just 2.25%, according to Citigroup (C) and S&P estimates. "We may be below that growth rate for a short time, but that doesn't represent a particularly difficult long-run valuation hurdle or growth requirement," notes Citigroup senior economist Steven Wieting in a Mar. 1 report.

That isn't to say economic concerns might not continue to create upheaval for the market. Further volatility could be in store in coming days, as investors assess data on employment, nonmanufacturing business activity, and January international trade, along with the Federal Reserve's Beige Book report. The Chicago Board Options Exchange Volatility Index (VIX.X), a measure of investors' risk tolerance often classified as a "fear gauge," rose 15.6% to 18.29 in afternoon trading Mar. 2, more than doubling its 52-week low of 8.6 set Dec. 18, 2006.

Counting on Corporate Profits

Former Fed Chief Alan Greenspan grabbed headlines this past week as he asserted a recession is "possible," but not "probable" in 2007 (see, 3/1/07, "Greenspan vs. Bernanke: Hold Your Bets"). The Institute for Supply Management's strong manufacturing report Mar. 1 may have eased some economic fears, but the housing market remains a question mark for investors. "The market should be moving up again once it becomes clearer that the housing recession and the subprime mortgage credit crunch are not spreading," says Ed Yardeni, chief investment strategist at Oak Associates, in a Mar. 2 report.

Until then, risk aversion bodes well for defensive plays, some analysts say. Health care and consumer staples were the only sectors to receive net analyst upgrades in the most recent week, following several months of sharp downgrades for staples, says Merrill Lynch (MER) analyst Brian Belski in a Mar. 2 report. As a further-from-consensus play, Belski recommends the telecom sector.

Investors should likely brace themselves for continued turbulence in the weeks ahead. The market's eight-month run of low volatility and steady gains may be over, but investors would do well to remember that one pillar of the market's strength, corporate profits, probably isn't crumbling just yet.

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