A Late Spring for Earnings?


By Eric Wahlgren The second quarter is supposed to be when the stock market finally gets its mojo back, but not if there are many more days like Apr. 11. The Dow Jones industrial average fell 2% after General Electric reported disappointing first-quarter earnings, while the Nasdaq composite index saw its worst close since February.

Wall Street analysts are forecasting that the as-yet-incomplete list of first-quarter results will continue to be negative. However, they still anticipate a rise in the second quarter, which would break a losing streak that has seen earnings decline through 15 straight months.

Despite the upbeat outlook for the second quarter and beyond in 2002, the market continues to wobble in early April. As of the 11th, the S&P 500 is off 2.6% so far this year. The Nasdaq is worse, down 10.7%. Only the Dow is showing a little oomph, having risen 3.6%. Even if second-quarter earnings are up as expected, a general sluggishness in share prices may continue, especially for technology stocks.

IBM'S DOOZY. In the near term, equities may not come back as strongly as investors have hoped for several reasons. Chief among them is that many companies haven't been issuing many reassuring pronouncements (see "The Outlook: Profits -- and Pessimism"). For instance, database software company Oracle (ORCL), a key technology bellwether, said on Apr. 9 that it didn't expect corporate technology spending to pick up all that much in the next three months.

The real doozy, of course, was IBM's (IBM) profit warning. A day before Oracle's comments, the granddaddy of computer makers cautioned that earnings would miss first-quarter forecasts due to the corporate tech-spending slump. It offered little hope for a speedy turnaround.

"Outlook trumps earnings," says Trip Jones, senior vice-president of securities firm Fulcrum Global Partners in New York. "The market is convinced we are in a recovery. But it is going to take a positive spin on the outlook to make the market go higher."

CONSUMER FATIGUE? Wall Street may not hear that upbeat spin until the second half, when analysts expect companies to finally resume spending on software, hardware, and information-technology enhancements. Despite violence abroad and rising unemployment at home, the plucky American consumer has kept the economy afloat by continuing to spring for everything from homes to cars to CDs.

"We don't think that we're going to see business pick up...until the second half of the year," says Jeffrey Kleintop, chief investment strategist with PNC Advisors in Pittsburgh, who expects consumer spending to tail off a tad in the months to come. "That's when you'll have a transition from a consumer-led recovery to a business-led recovery," he adds.

If business spending fills the void, Kleintop predicts that the S&P 500 will hit 1,225 by yearend, which would represent better than a 10% jump over current levels. Kleintop's optimism comes in part from the results of a survey of more than 120 chief executives by the Conference Board, a private research group. Released on Apr. 8, it found that more than 80% of those surveyed expect economic conditions to improve in the next six months, up from less than 42% in the previous survey taken three months earlier.

Still, investors may want to think twice before plowing money into stocks just yet. "The bulk of the gains are going to come at the end of the year," Kleintop says.

FAT MULTIPLES. Because earnings have yet to come back in force, stocks are still a little too richly valued to justify higher prices at the moment, Wall Street strategists argue. Companies in the S&P 500 are trading at an average of nearly 22 times their 12-month forward earnings, vs. 17 times before the boom of the late '90s. IT companies are even pricier, with multiples on average of more than 35, according to Donald Luskin, chief investment officer at investment-research firm TrendMacrolytics.

"While the market may be oversold in some sectors, older professionals in the investment community believe that earnings multiples are still a bit too high and need to be a bit more fat-free," says Alan Ackerman, market strategist at Fahnestock & Co. in New York.

The Israeli-Palestinian conflict is one factor keeping prospective buyers at bay, he says. And concerns about corporate accounting practices continue to weigh on the market in the wake of the Enron fiasco. IBM's stock was off more than 5% in trading on Apr. 11 after a report that it was the subject of a Securities & Exchange Commission probe. By the end of the trading day, the SEC said it had closed its investigation and would take no further action.

"NO IMPETUS." The market is "in an emerging crisis of confidence in which investors doubt corporate earnings, corporate management, investment bankers, and equity analysts," says Ackerman. "There is really no impetus to be an investor at the moment." He sees the market trading in a "tight range" in the second quarter before moving higher later in the year.

Reports on the nation's economic health are becoming increasingly positive, however, and an almost universal consensus says the U.S. is in recovery mode. Recent monthly reports on factory orders and job creation, for example, have topped economists' forecasts. "It takes a while for these numbers to trickle down to [company] earnings," says Fulcrum's Jones.

But profits are indeed expected to improve. Although analysts see profits for S&P 500 companies down by 12.7% in the first quarter compared with the year-ago quarter, they're predicting an increase of 5.8% in the second quarter, reversing the more than year-long downward trend. Then analysts forecast 26.9% year-over-year earnings growth in the third quarter, followed by a 40.5% surge in the fourth. (These First Call/Thomson Financial figures include the effects of an accounting change that alters the way companies enter the cost of acquisitions on their books.) "Analysts are expecting a very steep slope in earnings recovery," says Joe Cooper, a First Call research analyst.

THINK SMALL-CAP. With the major stock indexes seen as simply marking time in the short term, investment professionals say now is not the moment to dive into an index mutual fund. If investors can't stay away from stocks, "stick with big names with strong management, strong cash flow, and the ability to pay a respectable dividend or buy back their own shares," Ackerman says. Financial services powerhouse Citigroup (C) and pharmaceutical giant Pfizer (PFE) are worthy picks, he says.

PNC Advisor's Kleintop suggests taking a look at small-cap companies, because many are trading at a discount, have great earnings growth potential, and boast healthy fundamentals. But, he says, "Make sure they are managing costs well, since many small-cap companies don't have as good a cost structure as large caps."

Obviously, no investor wants to miss the boat once the market does come back. But it now looks like that boat is going to be dead in the water -- at least through the second quarter. Wahlgren covers financial markets for BusinessWeek Online in New York


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