The Earnings Season of Discontent


By Margaret Popper As earnings season arrives again, investors' minds this quarter are quickly turning toward thoughts of scandal, not profits. Where's the next Enron, WorldCom, or Xerox? Are other situations like Merck or Bristol-Myers Squibb ready to crawl out of the woodwork? How bad will it be?

With those kinds of doubts dominating investor psychology, the second quarter is going to be one of the most unusual earnings seasons Wall Street has ever witnessed. There's just no proven model to assess the impact of potential earnings restatements that CEOs are about to unveil.

One thing is sure: More than a few restatements will be made as investors loudly demand conservative accounting and as CEOs scramble to comply with new orders from the Securities & Exchange Commission or risk criminal liability. Beginning this August, CEOs can do jail time for misleading investors with any accounting sleight of hand, and that could mean correcting past mistakes as well as cleaning up the current books.

QUESTIONABLE BOOKS. For the leaders of Corporate America, it's not clear what standards will be considered conservative enough. They may go overboard to state their profits and losses in the most stripped-down terms, and even then investors may not buy their presentation. In this atmosphere of distrust, the market will undoubtedly react bearishly to restated earnings, masking what is so far a slow but fundamentally sound recovery.

One problem the market will have in trying to interpret second-quarter earnings is that Wall Street analysts' projections don't take restatements into account. Standard & Poor's is still projecting second-quarter earning per share of $12.44 for the S&P 500-stock index. That's a 15% increase over the $10.84 in the first quarter, and a 36% rise over the second quarter of 2001.

However, these projections were made using books that are now in question. And CEOs have kept pretty quiet about what they may do. "Managers really aren't saying anything. Either they don't have it, or they won't tell us what the numbers are," says Sam Stovall, chief sector strategist at S&P.

TOUGH TO INTERPRET. Market watchers fear that corporate managers will reveal their most negative earnings secrets at a time when their stock prices have already taken a beating, camouflaging any positive developments. "There's always a tendency to throw in bad news whenever year-over-year earnings performance is well under trend," observes John Lonski, chief economist at Moody's Investor Service. "We could see numbers that will be difficult for investors to interpret at face value."

As a result, once the restatements are out, the stock market could well make a downward structural shift so that price-earnings ratios are more in line with historical averages. That would be a positive long-term development but a painful one in the near term. Even with the S&P 500 at a discouragingly low 925, price multiples are still 32 times the past four quarters' earnings. That's more than twice the p-e level of 13 that's the average coming out of a postwar recession, observes S&P's Stovall.

While it'll take a while for investors to factor earnings restatements into their valuations, that shouldn't distract them from the important thing to note: which direction earnings are going. Profits are improving, judging by the national income and product account data that the government uses in calculating gross domestic product.

UPSIDE SURPRISE. In the fourth quarter of 2001, profits were 18% higher than in the previous quarter, according to national income data from the Bureau of Economic Analysis. And in the first quarter of 2002, they were about 1% higher than the previous quarter and about 5% higher than first-quarter 2001.

The market seems determined to ignore other bright spots in the economy, particularly on the consumer side. In the latest report, retail sales grew 1.1% in June, vs. a 0.9% drop in May. Outside of auto sales, they were up 0.4%, vs. a decline of 0.4% last month. That means consumers are still spending, bolstered by a 0.4% increase in wages in June. That's faster than the 0.1% increase in May, and it could indicate the beginnings of an improved job market.

Signs of firming are also showing on the corporate side. Companies have stopped slashing inventories, which fell only 0.2% in May, and capacity utilization appears to have stabilized. Work weeks and overtime hours rose in June, and new orders are slowly starting to improve.

SLOW BEATS NO. Risks to the economy remain. Capital spending has yet to pick up with the vigor economists were hoping for. Credit downgrades are still outpacing credit upgrades to the tune of almost 5 to 1, according to Moody's. These factors, combined with the stock market's malaise and the ongoing erosion of confidence in the system, are making it nigh impossible for businesses to start the spending spree that would really put the U.S. economy on a fast-growth track.

Even so, slow growth is better than no growth, and it can take the stock market a very long time to recognize that when sentiment is negative. As the famous quip goes, the market has predicted nine of the last five recessions. And with so much accounting distraction this earnings season, the market is likely to continue diverging more sharply from the fundamentals than it already has. This summer is shaping up to be anything but languid on Wall Street. Popper is a senior contributing economics editor for BusinessWeek


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