Earnings February 28, 2010, 9:43PM EST

Investors Scorn Bullish Earnings Forecasts

Stock index gains have stalled amid concern that Wall Street analysts have grown too optimistic about corporate profits in 2010

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Better-than-expected fourth-quarter earnings haven't dispelled fears on Wall Street that U.S. companies won't live up to this year's high profit expectations.

According to Bloomberg, analysts expect companies in the broad, large-cap Standard & Poor's 500-stock index to earn $78 per share in 2010. If accomplished, that would amount to a 32% gain above 2009 earnings—the highest earnings figure since 2007 and the third highest S&P 500 earnings gain ever.

Standard & Poor's equity analyst Alec Young warned in a Feb. 25 note: "The 2010 estimated profit bar is set very high."

Some investors believe a robust economic recovery will deliver such results. Although many remain skittish, the current estimate "is achievable as it stands now," says Mike O'Rourke, chief market strategist at New York-based brokerage BTIG. Stimulus from the federal government and low interest rates from the Federal Reserve will help companies rake in profits this year, he says.

Analysts were pleasantly surprised by results from the last three months of 2009.

Now that 457 of the companies in the S&P 500 have reported, earnings per share are up 154% from a year ago, an average of 5.5% more than analysts had predicted, according to Bloomberg data. Despite the weak economy, revenue for the S&P 500 rose 9.5%. Analysts had expected an increase of 8.2%.

P-E ratio has slipped from 15 to 14.2

"We continue to predict that the S&P 500 will move higher this year on better-than-expected earnings," Ed Yardeni, president and chief investment strategist at Yardeni Research, told clients in a Feb. 25 research note.

Since earnings season began on Jan. 11, however, the broad, large-cap index has slipped 3.7%. The S&P 500's price-to-earnings ratio, or P-E, a key measure of how highly investors value stocks, has slipped 5.5%—from 15 to 14.2, based on earnings expected in the next 12 months. That's the lowest level since April 2009.

Weak equity markets reflect investor fears that stocks are too expensive to live up to the hopes for 2010. "There is a lot of talk that valuations are too high," says Richard Sparks, an equity analyst who closely monitors investor sentiment at Schaeffer's Investment Research. Investors believe "the market has come too far too fast," he says.

John Wilson, chief technical strategist at Morgan Keegan, notes that, while earnings announced in the last quarter were better than expected, not all the CEOs who spoke on company earnings calls sounded optimistic about this year's results. Executives "continued to be a little cautious," Wilson says.

Technology stocks are an exception. On Feb. 4, Cisco Systems (CSCO) Chief Executive John Chambers sounded confident that the global economy was recovering well. "Almost every country is saying their momentum is better than it was before, and almost every business is saying it's more optimistic," Chambers said in an interview with Bloomberg News.

cutback in Consumer spending gain

By contrast, Wilson says, consumer company executives have sounded gloomy, especially with the U.S. unemployment rate at 9.7%. Earnings guidance from Wal-Mart (WMT) released on Feb. 18 caused analysts to lower their 2010 expectations. The giant retailer said it expects 2010 earnings of $3.90 to $4 per share, compared to an average of $3.98 forecast by analysts surveyed by Bloomberg.

On Feb. 26, new figures showed that U.S. gross domestic product grew 5.9% in the fourth quarter, more than the 5.7% previously estimated in an advance release. However, U.S. fourth-quarter consumption, or spending by consumers, was revised downward, from a 2% increase to a 1.7% increase.

For investors trying to value stocks, the key question is which customers will drive the increases forecast in corporate profits and sales, says Prudential Financial (PRU) market strategist Quincy Krosby.

"The biggest worry facing the market right now [is] whether or not global growth and global demand pick up," Krosby says. Data and headlines from Europe, Asia, and the U.S. have all spooked investors in recent weeks. "You don't see the kind of traction in the economy that will allow demand to pick up."

Peter Cardillo, chief market economist at Avalon Partners, believes the U.S. economy will grow fast enough to boost profits. He acknowledges that some on Wall Street are worried. "There is fear of the economy faltering," Cardillo says.

If U.S. companies do fulfill those earnings expectations, their stocks will turn out to have been great deals at today's prices. The S&P 500's forward P-E is currently at 14.2, while the average P-E over the past 20 years is 20.4, according to Bloomberg data.

Steverman is a reporter for Bloomberg BusinessWeek's Finance channel.