Q2 Earnings Results May Not Soothe Market Fears

A replay of better-than-expected profits may not impress investors worried about Europe's weakness and persistent U.S. unemployment

By Ben Steverman

With so many distractions confronting them this year, investors have found it easy to ignore corporate profits. That could change beginning on July 12, when companies begin reporting results from the second quarter that ends on June 30. Alcoa (AA), traditionally the first large-cap U.S. company to report quarterly earnings, is expected to release results on that date.

Analysts surveyed by Bloomberg estimate that earnings for the Standard & Poor's 500 index will rise 34.3 percent this quarter from a year earlier. Sales are estimated to increase 9.4 percent.

Rising profits could cheer a market that, in the case of the Standard & Poor's 500-stock index, has lost 10.3 percent of its value since Apr. 23. "Earnings could be the catalyst for a summer rally to gain traction," says Peter Cardillo, chief market economist at Avalon Partners.

Not everyone agrees. "I don't think it's going to matter much," says Bruce Bittles, chief investment strategist at Robert W. Baird.

In theory, corporate profits are the key driver of stock prices. "Earnings are the fundamental heart of stock analysis," says Doug Peta, chief strategist of Qualitative Associates. The basis of stock prices is the value of companies' future cash flows, he adds.

The stock market often ignores even excellent corporate results. The U.S. market's slide from late April to early June occurred as companies were reporting stellar profits.

will the market "shrug" off earnings?

In the first quarter of 2010, S&P 500 sales rose 12 percent, while earnings jumped 54 percent, beating the average analyst estimate by 14.2 percent.

Jack Kaplan, portfolio manager at Carret Asset Management, predicts similarly strong profits in the second quarter—exactly what you would expect during an economic recovery. "The only surprise is what reaction you get" to earnings, Kaplan says. "We're worried companies will do exactly what we think—and the market will shrug."

The problem for the stock market isn't recent profits but worries about future earnings. Gary Wolfer, chief economist at Univest Wealth Management, lists five major factors that are "keeping the market bottled up:" Uncertainty about how financial regulation will affect profits in the financial sector; the persistence of unemployment in the U.S.; worries about Chinese economic growth; worries about the fiscal situation in Europe, especially the debt troubles in Greece; and, finally, BP's (BP) failure to end its oil spill in the Gulf of Mexico.

Of these five uncertainties weighing on stocks, only the outlook for China has cleared up significantly, Wolfer says. "There is a lot of risk out there [and] as a result, investors are just dumping their riskier assets," like stocks, in favor of bonds.

The Federal Reserve acknowledged the impact of Europe's debt crisis on June 23. In a statement, the Fed's Open Market Committee said "financial conditions have become less supportive of economic growth on balance, largely reflecting developments abroad."

Was FedEx warning a negative signal?

These worries create a climate in which unexpectedly weak earnings could shock the market. "Because the market has been so skittish, [it] is susceptible to earnings disappointment," Peta says.

FedEx (FDX) raised eyebrows on June 16 when it warned that higher labor costs meant earnings for the next year could be lower than analyst had been estimating.

Recent economic data has also raised concerns about profits in particular sectors and industries. May retail sales fell 1.2 percent, after steady increases for the first four months of the year. In the second quarter, "retailers might not have as good a story to tell," says Jeffrey Kleintop, chief market strategist for LPL Financial.

What concerns Bittles and other bearish investors isn't so much that second quarter results will be weak, but that future profits are in jeopardy.

"The evidence is mounting [that] the economy is going to slow in the second half" of 2010, Bittles says. Data on June 23 showed that new home sales fell 33 percent, a record, from April to May. Although Bittles doubts that the U.S. will slip back into recession this year, the housing numbers are "not a great omen for the economy."

Do companies even rely on Europe?

Some other investors and economists continue to predict a strong economic recovery. Wolfer says the recovery is proceeding "two steps forward, one step backward." Russell Croft, portfolio manager of the Croft Value Fund, points out that data on U.S. industrial activity and productivity are strong, while companies have shown they have strong balance sheets.

Earnings reports, then, could arrive at a crucial time in this debate about the economy between optimists and pessimists. Kleintop says corporate results could remind investors just how little U.S. companies have been depending on Europe for growth—especially compared to Asia, where sales have remained strong.

A key piece of information from earnings reports will be the predictions issued by executives about the rest of the year. "It's all about guidance," Croft says.

If chief executive officers and chief financial officers sound confident about their prospects in 2010, it's a sign that the U.S. economic recovery is on track. If they sound cautious and can't see what's next, investors will have reason to be concerned. Then the market's recent malaise may deepen.

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

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