News Analysis
BusinessWeek.com
June 26, 2006
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Will Earnings Boost Stocks?

Companies in the S&P 500 should report decent results for the second quarter. That might not be enough to prevent a summer slump

In the next few weeks, investors may get some relief from second-quarter earnings reports. But given the high anxiety about higher interest rates and a slowing economy, analysts say another quarter of solid earnings might not be enough to calm a choppy stock market.

The current quarter could test the Standard & Poor's 500 index's streak of 16 consecutive quarters with double-digit percentage earnings growth. S&P projects that second-quarter earnings will increase 9.1% from the same period a year earlier. Declining consumer spending and higher energy costs are among factors contributing to slower earnings growth, according to Howard Silverblatt, senior index analyst at S&P. "While that will still be record earnings, it's going to be somewhat of a disappointment to a lot of investors because it's single digits," he says.

Slower earnings growth is not the only problem. Worries about inflation and a global uptrend in interest rates are likely to keep the market on its current unsteady course, some analysts say. "Solid real growth and the return of a little bit of pricing power will extend the already-record string of double-digit earnings for S&P 500 companies," wrote Steven Ricchiuto, chief U.S. economist at ABN AMRO (ABN ), in a June 26 report. "Upbeat earnings, however, will not provide much support for stocks."

GREAT EXPECTATIONS.  So far, second-quarter earnings releases have been promising. Big investment banks Bear Stearns (BSC ), Goldman Sachs (GS ), Lehman Brothers (LEH ), and Morgan Stanley (MS ) reported surging profits (see BusinessWeek.com, 6/22/06, "Boom Times for the Powerhouse Banks"). Results from tech bellwether Oracle (ORCL ) and transportation company FedEx (FDX ) also topped analyst estimates.

Coming next will be a report from aluminum giant Alcoa (AA ) on July 10. Then the season gets into full swing the week of July 17, with releases from closely watched companies such as Citigroup (C ), Johnson & Johnson (JNJ ), Yahoo (YHOO ), Apple Computer (AAPL ), Intel (INTC ), and Microsoft (MSFT ).

A lack of negative guidance bodes well for the companies yet to report, notes David Chalupnik, head of equities at First American Funds. "Typically, if corporations were running into trouble relative to expectations, you would see a lot more companies coming out and reducing expectations," says Chalpunik, who expects 11.5% earnings growth. "We've seen very few of those."

OVERCOMING OBSTACLES.  Investors can expect a few positive surprises, some analysts say. Earnings have beaten sell-side analysts' predictions for 10 consecutive quarters, and there's a chance they could do so again, according to Tobias Levkovich, chief U.S. equity strategist at Citigroup. "Many investors remain worried about margin pressures and a sense that all good things must come to an end," he wrote in a June 22 report.

The energy and financial sectors will probably post the biggest profits gains, according to Joe Battipaglia, chief investment officer of Ryan Beck. He expects additional strength from the industrial sector, and to a lesser extent, technology companies. (S&P forecasts a 1.9% second-quarter profit decline for the technology sector.)

"This is going to be a better-than-expected earnings season," Battipaglia says. "The message from the companies will be that despite obstacles, they're still hitting their profit targets."

LIMITED GAINS.  As was demonstrated last week, any market bounce from second-quarter earnings surprises will likely be similarly short-lived, some analysts say. Jeff Kleintop, chief investment strategist at PNC Wealth Management, forecasts another quarter of double-digit earnings growth as low labor costs keep profit margins wide.

However, he believes that midterm elections, hurricane season, and the housing slowdown will limit gains in stocks. "There's probably not a whole lot more downside to this market, but I think we'll need to get used to these 100-point daily moves," Kleintop says.

Indeed, a quarter of solid but slower earnings growth may already be priced into the markets, says Art Hogan, chief market strategist at Jefferies & Co. He projects an increase in second-quarter profit of 8.5% to 10%. "Are equity prices already reflecting what is the inevitable earnings growth deceleration, or are they just reflecting concerns that the Fed is going to raise interest rates too much?" Hogan asks. "It's certainly a combination of both."

PERKING UP.  Market players will be keeping a close eye on companies' earnings guidance. Eventually, rising interest rates worldwide are going to dampen economic growth, notes Quincy Krosby, chief investment strategist at The Hartford (HIG ). "That is going to have an effect on earnings," she says. "The key for us is, how much of an impact."

Actually, later in the year, corporate profits are expected to perk up again. S&P forecasts earnings growth of 13% for the third quarter and 11% for the fourth quarter, for a full-year gain of 12.1% from 2005. "We believe consumer spending is going to come back," Silverblatt says.

One thing investors should remember: Not all earnings growth is created equal. A flurry of share buybacks has made earnings-per-share increases at companies like ExxonMobil (XOM ) look even more dramatic, inflating price-to-earnings ratios, says S&P's Silverblatt (see BusinessWeek.com, 5/5/06, "Second-Quarter Preview"). And with jitters already haunting investors, any slipup could keep the markets on edge.