Earnings: Another Season of Discontent?


By Amey Stone September is historically a bad month for the markets. In part, that's because it's typically when analysts, who have coasted through the summer hoping for the best, get back from vacation and face the cold, hard truth of how corporate profits are shaping up for the rest of the year. After seeing early numbers, sharpening their pencils, and running some projections, they often don't like their conclusions. "Reality starts to take over from fantasy," explains Sam Stovall, chief investment strategist at Standard & Poor's, "and estimates and prices come down."

Now comes September, 2002, and the approaching period of reassessment could be particularly ugly. Many analysts' projections were predicated on earlier forecasts for a strong second-half recovery in corporate spending that has yet to materialize. The third quarter got off to a terrible start in July, as corporate scandals shook investors' confidence. Since then, the stock market has staged a healthy bounceback, and the economic news in August was a bit more encouraging. But in the weeks ahead, investors should stand vigilant.

MANY RED FLAGS. The market is just entering the "preannouncement" phase, which occurs every quarter when corporations that won't meet earlier forecasts break the news to Wall Street. Already, the number of warnings is running higher than usual. According to earnings tracker First Call, 52% of preannouncements so far in the third quarter for S&P 500 companies have been below expectations, while only 22% have been above. In contrast, at this point in the second quarter, only 38% of earnings preannouncements were below expectations and 34% were above.

These numbers are reversing a trend in the last few quarters that saw an improvement in the ratio of negative to positive preannouncements, says Joe Cooper, a research analyst at First Call. Most warnings won't come in until the last two weeks of September and the first two weeks of October. But preannouncements typically grow more negative as the quarter wraps up. So far, says Cooper, "It's kind of an ominous trend."

But not surprising, given the drumbeat of warnings investors have been hearing for months. As of July 1, analysts predicted 16.6% earnings growth for the S&P 500 in the third quarter. Now, they're forecasting 11% growth. Based on usual trends in earnings revisions, says Cooper, that number is likely to keep coming down, probably by five more points.

WINTER BLUES IN FALL. In another worrying sign, analysts are taking down their estimates for the fourth quarter as well -- and just as rapidly, says Cooper. As of July 1, they were predicting earnings growth of 27.7% in the final period. Today, they forecast 22.6% growth. "That's unheard of," says Cooper. "Five percentage points of growth have already been removed, and we're still three weeks away from the quarter beginning."

When all is said and done, Cooper thinks third-quarter 2002 earnings will have grown 8% over the same period last year, which is certainly an improvement on the year-to-year 1.4% growth registered in the second quarter and the first quarter's 11% decline. He says it's still early to speak with any certainty of the fourth quarter, but Cooper's current estimate is for 15% profit growth. That's still a nice increase, but it's not the rebound most investors were hoping for.

Mark Zandi, chief economist at Economy.com, points out that everyone started the year hopeful that profits would snap right back, but so far they're only slowly coming back. "So there's a great deal of disappointment," he says.

The good news? Most investors aren't really worried that the U.S. is slipping into a double-dip recession, although Zandi still says there's a 33% probability of this happening. A more likely scenario, however, is that earnings could trudge along indefinitely at this low level of recovery -- with growth coming mainly from cost-cutting. "You can't cost-cut your way to prosperity," says Trip Jones, a vice-president at investment firm Fulcrum Global Partners, who adds: "I'm less concerned with how deeply we go on the downside than I am with how long we may be here."

TALK LOW, SHOW HIGH? Even investment strategists who are far more bullish on an earnings recovery think the preannouncement season could be rough. The reason: These days, companies are so afraid of disappointing Wall Street their forecasts are extremely conservative. In the end, "I think actual earnings will be a pleasant surprise for investors," says Milton Ezrati, senior economist and strategist at Lord Abbett & Co. "But I think there will be a lot of negative preannouncements because corporate managements are loath to show any optimism. They much prefer to talk down the numbers and surprise on the high side."

S&P's Stovall still believes that the stock market hit its 2002 low in July. But he also expects the market to dip again in the weeks ahead, and it may come close to those midsummer lows.

Investors are eager to put the shock of corporate scandals and the sorrows of September 11 behind them. And better days surely lie ahead. But a continued ratcheting back of hopes for a surge in corporate profits could be another reason for caution in the weeks ahead. Stone is an associate editor of BusinessWeek Online and covers the markets as a Street Wise columnist and mutual funds in her Mutual Funds Maven column


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