Markets & Finance

Earnings: So Much for Visibility


It's hard to imagine how analysts could have been more wrong about corporate profits last quarter. When will earnings stop their slide?

If you're an analyst who tries to predict corporate earnings, you should be feeling a little abashed these days.

All but a few results are now in from the brutal fourth quarter of 2008. On Oct. 1 analysts thought earnings for the broad Standard & Poor's 500-stock index would rebound 46.7% from the year before, according to Thomson Reuters (TRI). By the end of the quarter, on Jan. 1, analysts were predicting earnings would fall 1.2%.

Instead, with about 90% of results released, earnings are projected to fall 42.2%.

"Business, consumers, and financing froze in the fourth quarter of 2008," says Mark Giambrone, manager of the USAA Growth & Income Fund (USGRX).

Thomson Reuters' director of research, Ashwani Kaul, says the "big culprit" is financial stocks, which saw earnings plunge about 750%. That eye-popping drop was accomplished by swinging from earnings of $5.2 billion a year ago to a loss of about $34 billion last quarter.

Rewritten the Rules

Among financial stocks there has been a "paradigm shift in earnings models," says Uri Landesman of ING Investment Management (ING). The credit crisis has rewritten the rules of how banks and other firms operate. They will need to rely on less leverage, for example. "Who knows what the earnings potential is [for] the financials?" he says.

Outside of the financial sector, analysts might have been a bit more accurate. But, even without financials, earnings for the rest of the S&P 500 still would be down 19%.

As long as the bulk of losses remain among banks, homebuilders, retailers, and others directly affected by the crisis, there is some hope, says John Merrill of Tanglewood Wealth Management. Outside those areas, the drop in earnings looks more like a normal, run-of-the-mill recession. He says about 80% of firms "are holding up very well."

Second-Half Scenario

Merrill hopes that can continue in 2009, preventing an especially deep recession in the process. "That's critical to the underlying health of the economy," he says.

Analysts are predicting that the fourth quarter of 2008 is the worst earnings will get. According to S&P, some analysts say that by the second half of 2009 operating earnings should rebound from their rock-bottom levels in late 2008. For the whole of 2009 earnings for the S&P 500 actually should be up 21.3% —after falling 33.5% in 2008.

Many investors simply aren't buying it. And neither are many analysts, who on a daily basis seem to turn more pessimistic and push their earnings estimates lower. "They're gradually cutting earnings forecasts and catching up to reality," says Scott Schluederberg of Hardesty Capital Management.

'Overly Optimistic'

Robert Siewert, a portfolio manager at Glenmede, agrees that 2009 estimates "still look overly optimistic." Consumer spending will remain under pressure as layoffs continue and the unemployment rate heads higher, he says.

The last quarter demonstrated how much corporate earnings befuddle analysts. But it's not just analysts who are confused. Executives planning corporate budgets—and investors picking stocks—are fogbound as well. "The lack of visibility is very, very high," USAA Growth & Income Fund's Giambrone says.

The problem for investors is that earnings are typically used as a measure of equities' fair value. The price-to-earnings ratio is a handy and popular measure of what a particular stock price ought to be. But because of the invisibility of future earnings, "2009 is extremely difficult to value stocks on," Giambrone says.

Only Way to Go is Up?

The financial sector has been the main contributor to the wild unpredictability of corporate earnings from quarter to quarter. Financials might also be the solution. "Until we get stability in financials, it's going to be very difficult to predict" future earnings trends, says Kaul of Thomson Reuters.

Earnings are analyzed on a year-over-year basis. Thus, if there's one silver lining to this earning season's grim results, it is that a rebound a year from now is considered almost inevitable. It may take a long while to return to 2006's robust earnings, investors and analysts say. But, the fourth quarter of 2008 was so bad that the fourth quarter of 2009 can't avoid being at least a little better, right?

Unfortunately, that's what investors said a year ago: S&P 500 earnings in the last quarter of 2007 dropped 25.1%. Amid the unprecedented economic and financial turmoil of the current crisis, all bets are off.

Steverman is a reporter for BusinessWeek's Investing channel.

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