By Amey Stone Nobody likes a spoilsport, but even as investors rejoice in all the recent economic glad tidings, it needs to be said that the recovery is still vulnerable to a setback. Sure, the housing market is remarkably robust, gross domestic product is growing, and the beleaguered manufacturing sector is perking up. However, all those positives could reverse unless the underlying demand for goods and services increases -- especially on the business side, say economists.
Most of them just don't know where that demand is going to come from, which could be dangerous for investors in the near term. "Overly optimistic extrapolations from preliminary readings of the available data could turn out to be a headlong leap into the shallow end of the pool," warned David Gitlitz, chief economist at research firm TrendMacrolytics, in a Mar. 5 note to clients.
LESS OOMPH LEFT. Consumer spending, which makes up more than two-thirds of GDP, continues to prove surprisingly robust since the terrorist attacks last fall. The Federal Reserve's 11 rate cuts last year are clearly stimulating growth, as demonstrated by the recent surge in housing prices and auto buying. But most economists and strategists say consumer spending has less ability to boost demand from here.
"I have real concerns about the sustainability of recent economic improvements and consumer spending if we do not soon spot an improvement on the labor front," says John Lonski, chief economist at Moody's Investor Services. He also points to renewed military conflict, rising energy prices, and sharply dropping exports as reasons for continued concern. Consumer-confidence survey numbers also dipped recently, but he thinks the surge in equity prices may have already reversed that.
With consumers having done their part, it's now up to businesses to kick-start demand with renewed capital spending and hiring. Federal Reserve Chairman Alan Greenspan has repeatedly pointed out that the current recession was triggered by business cutbacks and said he'll need to see improved corporate demand there before he's convinced the recovery is sustainable.
DECLINING PROFITS. Surveys of corporate buyers have consistently shown they plan only a gradual pickup in spending this year. Only 15% of respondents to a National Association of Manufacturers survey released on Feb. 20 said they would increase capital spending by more than 5% in the first half of 2002. For the second half of the year, 25% of respondents said they expect to increase spending more than 5%, but 54% said their increase would be in the zero-to-5% range.
A little bit of activity on the business side can go a long way, but companies won't start buying equipment and hiring back workers in earnest until profits pick up, most economists and analysts say. The recent Commerce Dept. report on durable goods orders and the Institute for Supply Management manufacturing-activity report have encouraged investors that capital spending may be starting to rebound. The reports point to an upturn in profits, says Lonski, but he's quick to caution that they're just preliminary indicators.
Meanwhile, corporate profits are still falling. Earnings in the first quarter will probably be about 11% worse than last year's first quarter, according to research firm First Call. That's an improvement from the 22% year-over-year decline in earnings seen in both the third and fourth quarters of 2001, but profits aren't projected to start improving until the second quarter, when First Call expects 6% growth.
BULLS' LOGIC. Why, then, the early March rally in stocks? Bulls believe corporate earnings just need to stabilize to set the stage for a robust recovery six months from now. First Call's consensus of industry analysts projects year-over-year earnings growth of 32% in the third quarter and 42% in the fourth. That sounds spectacular at this juncture, but part of the gains should come from easy comparisons, since earnings fell off a cliff in the third quarter last year. But bulls also argue that sales don't have to increase much for earnings to dramatically improve, since companies have cut costs so much.
From there, the bullish scenario further assumes that a pickup in earnings will create momentum for a real jump in corporate spending and the longed-for increase in demand. "Companies are generating cash, sitting on large piles of money," says Ryan Jacob, president of Jacob Asset Management. He thinks an improved economy and recent stock market gains will also lift corporate confidence, and chief executives will start spending. "Then there will be some underlying momentum to the economy," he says.
More good news is clearly needed before a real change in corporate psychology is likely. That's why first-quarter results could be ugly. Companies that are going to miss analysts' targets will start coming clean in the next few weeks during "preannouncement" season. Oracle (ORCL) told investors late on Mar. 1 it would miss earnings forecasts by a penny a share for the quarter ended in February. The stock fell $2.32, or 15%, to $13.67 on Mar. 4, a day the Dow Jones industrial average climbed 218 points.
COUNTING ON SURPRISES. Perhaps even more important to the outlook for the year and the market's near-term health is the period in mid-April when companies report first-quarter profits and offer second-quarter forecasts. With stock prices this high, investors will need to see some positive surprises to back up the optimism. Expectations already are high, especially in the technology sector, where analysts forecast 138% growth year-over-year in the third quarter and 74% growth in the fourth quarter. Stocks in that sector are trading at twice the price-to-earnings ratio of the Standard & Poor's 500-stock index (44 times forward earnings, vs. 22 for the S&P), according to TWP Growth Strategy Group.
In an improving economy, corporations need to anticipate a pickup in demand and start investing in people and equipment or they'll be caught short when customers come back. Investors are buying stocks now, betting companies will start that process soon. But keep in mind that the economy is still several steps away from such demand actually materializing. Over the long haul, investing in stocks is a crucial part of any diversified portfolio. But in the short term, if stalling demand delays the recovery, stocks could get hit hard. Stone covers financial markets for BusinessWeek Online in New York