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Earnings Growth: Too Good to Last?

Corporate profits are coming back. The only question is for how long.

Even pessimistic investors expect strong results from U.S. companies when Alcoa (AA) kicks off first-quarter earnings season on Apr. 12. "This quarter's profits are going to look quite robust," Palantir Fund (PALIX) portfolio manager Tom Samuels says, even as he predicts a downturn for profits and the economy later this year.

Analysts surveyed by Bloomberg predict first-quarter earnings for the large-cap Standard & Poor's 500-stock index will rise an average of 31.7% from a year earlier. In a sign the economy is rebounding from the Great Recession of 2008 and 2009, sales are projected to rise 10.5%.

Companies revealing results from the first three months of 2010 have a lot going for them. They slashed costs and are benefiting from a U.S. economy that grew 5.6% in the last quarter of 2009. Action Economics expects U.S. gross domestic product to rise another 2.5% in the first quarter of 2010. Most of all, corporate results will look great when compared with a year earlier, when, as Samuels says, "we were in the grip of that last panic move down in the markets."

Recovery in Profits

With the recession over, it will become easier for U.S. companies to generate profits, says J.J. Schenkelberg, portfolio manager at CLS Investments in Omaha. Outside of the financial sector, she says, "we're not too far away from normal."

The recovery in profits has been rapid, with S&P 500 earnings increasing 98.5% in the last quarter of 2009. "A lot of companies are back to the profit levels that existed back in the 2007 peak," says Brad Thompson, fund manager at Frost Investment Advisors in San Antonio.

Apple (AAPL) is a leading example. When it posts results on Apr. 20, Apple is expected to report a 37% growth in earnings per share and a 31% rise in sales. Analysts expect Wal-Mart (WMT), which reports May 18, to post a 9.9% increase in earnings and a 4.4% rise in revenue. A year earlier, the world's largest retailer saw sales fall 0.7% and managed only a 1.3% increase in earnings.

According to Bloomberg, the biggest rebound will come from the materials sector, which analysts expect to boost earnings from $1.69 billion to $4.98 billion, a 195% rise. Of the 10 major sectors of the S&P 500, only telecommunications and utilities are expected to see earnings fall, by 4.2% and 1.6%, respectively.

Market Reaction

Despite the good earnings news, Wall Street won't necessarily be celebrating. "While investors might not be overly disappointed by earnings, they may once again be disappointed by the market's reaction," Barclays Capital head of U.S. equity strategy Barry Knapp wrote in an Apr. 1 report. He noted that share prices fell in the first three to four weeks of the last two earnings seasons, even as earnings surpassed analyst estimates.

Investors may be cautious because stocks have already risen quickly. With the S&P 500 up 42.3% in the past 12 months, stocks are at "fairly full valuation," Schenkelberg says. Even as profits rise, she says, "we run the risk of there coming a time when actual results can't meet expectations."

Another reason investors may ignore strong results is that many believe the profit rebound is only temporary.

"The consensus view is that all the improvements in corporate earnings and the economy are illusory," says Phil Orlando, chief equity market strategist at Federated Investors (FII). He believes the economic recovery can sustain itself, but many others believe that the rebound has been built on stimulus from the federal government—"and the whole thing is going to roll over and die in the second half of the year," he says.

Palantir's Samuels warns that "there really has been little if any structural repair of the economy." Look more closely at this season's financial-sector earnings for an example, he says.

Financial Earnings

Analysts expect the entire S&P 500 financial sector to boost net income by $5.16 billion, a 28.3% rebound from the depressed levels of a year earlier. But 32 of the 79 companies in the sector are expected to report lower profits. Within the financial sector, bank and real estate profits are expected to fall, while net income for insurance and diversified financial companies is expected to rise.

Samuels says he will be looking "under the surface" at financial earnings. If many financial companies are still showing weakness, "that is a good indication that all is not well," he says. Sales at consumer discretionary companies will also demonstrate how much consumers have returned to stores, he says.

Even if the economic recovery can continue, analysts may be too optimistic about results in the future, says Frost's Thompson. According to Bloomberg, analysts predict S&P 500 earnings to rise 28.3% in 2010 and another 20.5% in 2011, when projected earnings of $687.8 billion should top 2006's record haul of $628.8 billion.

"We're going to get a peak in economic momentum this year," Thompson says, arguing 2011 expectations are too high. By next year, profits will be sapped by higher tax rates and higher commodity and labor costs, he says.

This earnings season is "going to be a home run," Federated's Orlando says. But it is unlikely to end the debate between bulls and bears over the strength of the economic recovery.

Steverman is a reporter for Bloomberg News in New York.

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