Will Quarterly Reports Raise Red Flags?

Results for January to March may deliver important clues on the state of the economy and where the market may be headed

by Ben Steverman

The first-quarter earnings season is kicking into high gear at an uncertain time for investors.

The U.S. economy teeters close to recession. Consumers are slowing their spending, gasoline and crude oil prices hit new records, and home prices tumble ever lower. Meanwhile, the financial crisis drags into its ninth month with no end in sight.

How bad is it out there, and how bad will it get? The fog may lift soon: Companies' earnings reports from the first three months of the year began arriving on Apr. 7—with a disappointing update from Alcoa (AA)—and will continue for several weeks. By scrutinizing financial results and listening to executives' commentary, investors might get a better handle on where things stand.

BusinessWeek asked some experts—fund managers and analysts—which early earnings reports they will be watching closely in the next couple of weeks. These stocks might provide early clues on the direction of the economy and markets in the months ahead.

Merrill Lynch and Citigroup

Merrill (MER) and Citi (C), which both report on Apr. 18, were bruised and battered by the U.S. subprime mortgage crisis. The bleeding is expected to continue in this quarter, with multibillion-dollar writedowns of bad debt anticipated.

Ashwani Kaul, an analyst at earnings-tracker Reuters Estimates (RTRSY), says he's looking for Merrill and Citi to follow the lead of UBS (UBS), which "wrote off the kitchen sink" by announcing $19 billion in losses on Apr. 1 (BusinessWeek.com, 4/1/08).

Financial firms should take maximum losses now—by, for example, writing down bad debt to 10¢ on the dollar, not 40¢, Kaul says. It's the best way to put the financial crisis behind us, he says. "Stocks are going to be rewarded for just writing everything down and going forward."

By this logic, the larger the writedowns that Merrill and Citi can take on Apr. 18, the better for the long-term health of the financial system.

Caterpillar and United Technologies

Big industrial firms such as Caterpillar (CAT) and United Technologies (UTX) have seen strong sales overseas. Huge spending on infrastructure around the world has put their products in demand, while a weaker dollar has made their products even more attractive and widened international profit margins.

Gary Wolfer of Univest Wealth Management (UVSP) expects that trend to continue when United Technologies and Caterpillar report results on Apr. 17 and Apr. 18, respectively. Strength overseas should help those companies prosper despite a recession in the U.S., he says. "I think they're going to weather the storm very well."

Wolfer and many other investors, however, will get concerned if these firms' international sales start to deteriorate. That could be the first signs that the U.S. slowdown is spreading to Europe or other parts of the globe.

JB Hunt Transport

The outlook for the U.S. transportation industry is ominous. An economic slowdown means there are fewer goods to ship around the country, and higher fuel prices make moving freight more expensive.

Longbow Research recently surveyed many executives at trucking companies of all sizes, and 87% said they expect a recession this year. "We are in a recession now, and it's going to get worse before it gets better," said one respondent.