Two Sides to Earnings
Some Spot Signs of Sustainable Growth,
While Others See Profits Hitting a Peak
July 22, 2004
The Issue
Second-quarter earnings are unfolding nicely.
About 94% of companies that have checked in so far have met or exceeded analysts' estimates. Wednesday, blue chips like Eastman Kodak Co. and J.P. Morgan Chase & Co. were the latest to do so. Companies are on track to exceed consensus forecasts of 24% annualized earnings growth for the quarter, according to Nick Raich, research director for Zack's Investment Research.
It looks like we are well on our way to chalking up a ninth straight quarter of year-over-year earnings gains, and the fourth consecutive quarter of 20% or better growth. Yet, stock indexes have been downright lethargic lately.
What's not to like?
On the One Hand
The bearish case against second-quarter profit performance seems, at first glance, a matter of ingratitude.
Since last year, investors were impressed by the magnitude with which profits exceeded forecasts. Coming off a long period of economic uncertainty leading up to the Iraq war, corporate performance looked especially impressive. Profits have beaten expectations by at least 5% for five straight quarters, according to Merrill Lynch. They're still exceeding forecasts -- growth for the second quarter could come in as high as 28% to 30%, according to some estimates.
But investors are no longer impressed. "Upward surprises," Citigroup economist Steven Wieting wrote last week, "truly would not be much of a surprise after five quarters of large positive surprises."
This "
what-have-you-done-for-me-lately" attitude is reflected in the major stock indexes, which have been grounded this year despite a first-half profit performance that clearly has lived up to high expectations and then some. The Standard & Poor's 500-stock index has fallen a little more than 1% since Jan. 1, and the Dow Jones Industrial Average is down 3.9% on the year. Companies have felt the pain of not living up to heightened expectations: Yahoo shares have tumbled more than 10% since it disappointed investors, and eBay was stung fast in after-hours trading Wednesday following its report because investors were dismayed at the online auction giant's revenue growth.
The running story is that investors are distracted from positive profit reports by an economy facing headwinds in the form of rising interest rates and oil prices, an uptick in inflation, continuing troubles in Iraq and a coming presidential election that could go either way.
But what seems to be really weighing on investors' minds is the likelihood that the second quarter will mark the peak of this earnings cycle. Forecasts for the third and fourth quarter call for growth of 15% and 14%, respectively, according to Mr. Raich. Some project single-digit earnings growth in 2005.
This deceleration has long been anticipated. And even though earnings growth rates in the midteens are nothing to sneeze at, neither do they inspire the kind of awe and wonder that propels stock prices higher. Companies may have exhausted, for now, their ability to wow Wall Street with unanticipated gains.
Bank of America Securities' strategist Thomas McManus notes that only about 38% of companies' second-quarter earnings revisions were to the upside, and that this figure took a sharp turn for the worse after June 30. While he cautions against drawing overly bearish conclusions, he does allow that it shows good news will be harder to come by going forward. "We're probably at the point where we've seen the maximum number of companies report raised earnings guidance," he says.
Similarly, Zack's Mr. Raich notes that the ratio of negative to positive earnings preannouncements spiked to 2.5 to 1 over the past two weeks. That's higher than the 1-to-1 ratio that prevailed over most of the past month, though it's still below the five-year average of 3 to 1. "It's something we're keeping an eye on," says Mr. Raich, who is otherwise bullish about the earnings outlook.
On the Other Hand
Bulls can take comfort in the fact that as earnings rise and prices remain stable, the price-to-earnings ratio declines, meaning stocks are becoming cheaper.
Hugh Whelan, a senior portfolio manager at ING Investment Management, argues in a recent note to investors that the S&P 500's trailing P/E ratio is the lowest it has been since 1997. But P/E ratios tell only part of the story.
Stock returns are also attractive compared with bond yields that are still near generational lows. Mike Thomson, research director at Thomson Financial, recently examined the stock market's risk premium -- a widely used measure of the annual return stock investors can expect, on average, above Treasury yields.
Thomson calculates the risk premium, which factors in projected earnings as well as the relative level of interest rates, currently is at 8.3 percentage points, compared with a historical average of 6.5 points.
For that gap to close, either forecasted earnings gains would have to come down significantly or stock prices would have to rise. The latter is far more likely, he says. "It's very rare to go from the kind of earnings growth we've seen to where it falls of a cliff," he says.
Thomson speculates that so many consecutive quarters of more than 20% growth in earnings has put investors on edge. They may be worried that a continuation of such robust growth might be viewed as inflationary. If that's the case, slower earnings growth wouldn't be such a bad thing, as long as profits remain positive.
"We've seen that the market tends to perform better when the level of earnings growth is seen as sustainable," he says.
Write to David Landis at ontheotherhand@wsj.com
