Magazine

The Profit Picture Could Get Uglier


For almost three years, the companies tracked by the Standard & Poor's 500-stock index cranked out record profits, beating forecasts by a mile. Then the fun stopped. Earnings growth of 14.3% in the fourth quarter of 2005 was nothing to complain about -- except that it missed Wall Street expectations by more than two percentage points.

Just a fluke? Some prominent pundits think not. As the first-quarter earnings season kicks into gear with Alcoa Inc.'s (AA) quarterly announcement on Apr. 10, they say a surprising number of companies will miss by even more than they did when they reported fourth-quarter results in January. "There are going to be more big negatives than there have been in the past, and those will make headlines," says Gordon B. Fowler Jr., chief investment officer of Glenmede Trust Co. in Philadelphia, which manages $14.8 billion.

That's especially worrisome for investors given that first-quarter forecasts have already been ratcheted down since the start of the year. Consensus estimates peg earnings growth for the S&P 500 at 11.3% for the three months ended Mar. 31, according to Thomson Financial (TOC), down from a projected 12.6% on Jan. 1. Morgan Stanley (MS) Chief Economist Richard Berner says by the end of the year the Street will need to lower its growth estimates from 13.3%, to 7.5%, a huge drop. "Analysts should start to pull in their horns," he says, and tighten their estimates to reflect the weakening he sees. If his prediction proves correct, by the second quarter the S&P 500 will break its streak of 12 consecutive quarters of double-digit earnings growth -- a feat matched only once since 1950, notes Thomson Financial.

Not everyone is bearish. "I still think there are relatively robust profits out there," says Richard Yamarone of Argus Research Corp. in New York, citing strong first-quarter economic growth. He calls the bears "Negative Nellies."

April is a critically important month. First-quarter earnings reports give analysts the first glimpse of what the calendar year might look like. They'll readjust their entire 2006 forecast based on these numbers. A series of severe earnings misses would take investors by surprise and almost certainly roil the stock market.

To be sure, the fourth-quarter earnings results roiled nothing; stocks finished January higher. But if history is a guide, the numbers were ominous. Analysts tend to underestimate earnings growth at the beginning of an economic rebound and throughout most of an expansion. But late in the business cycle they tend to overestimate earnings growth, assuming the good times will last longer than they actually do. The fourth quarter might have been the turning point.

That's especially so given the interest rate environment. When short-term rates are higher than long-term rates, as they were during much of the first quarter, the result has always been an earnings recession -- meaning profits actually fall -- noted Merrill Lynch & Co.'s (MER) North American economist, David Rosenberg, to clients in December.

Some say the likelihood that today's low long-term rates reflect a foreign appetite for Treasuries more than bearishness over American growth prospects means corporate earnings might stay in the black this time. But short-term rates are the real issue. As they rise, says Berner, so will borrowing costs, denting profits.

For investors, a scenario of overly optimistic earnings estimates isn't a happy one. Says Fowler: "We're in for a choppy market."

By Mara Der Hovanesian


American Apparel's Future
LIMITED-TIME OFFER SUBSCRIBE NOW

(enter your email)
(enter up to 5 email addresses, separated by commas)

Max 250 characters

 
blog comments powered by Disqus