Fundamentally: This Time, Corporate Profits May Not Save the Day

But after the Dow Jones industrial average plummeted nearly 700 points last week — pushing stocks down 11 percent from their late April peak — Wall Street investors are finally waking up to what Main Street households have known all along: The already bad economy is getting worse. And the laundry list of problems that could tip the economy into another severe downturn, if not a recession, is growing only longer.

First, there’s the debt-ceiling debate in Washington, which isn’t over yet as a special Congressional panel will try to find $1.5 trillion in additional savings by November. On top of that, there are the still-growing debt problems in Europe.

“There’s a growing sense the Continent is in denial and investors will continue to stress those markets until something gives,” said Jack A. Ablin, executive vice president and chief investment officer at Harris Private Bank. “Bailouts don’t appear to be cutting it.”

And, on another front, it remains to be seen whether the Federal Reserve will step up again to try to stimulate the economy, as it did last November when it started to buy Treasury securities in hopes of keeping interest rates low. 

Just about the only bright note has been corporate earnings. Profit among companies in the Standard Poor’s 500-stock index are thought to have grown 18 percent, on average, in the second quarter versus the year-ago period, according to figures tracked by Capital IQ. That’s an increase from July expectations for profit growth of around 12 percent. The new figure stands in stark contrast to government reports showing that economic growth slowed drastically in the first half of the year.

 “But earnings and earnings revisions are a lagging indicator,” said Sam Stovall, chief investment strategist at S. P. Equity Research. Historically, he noted, corporate profits don’t reach a trough until around nine months after a bear market ends. And they typically don’t peak until after a bull market runs its course.

Does that mean that this bull run, which began in March 2009, may be over?

It’s hard to say. To enter another bear market, the Dow would have to tumble a further 1,200 points or so. Then again, after days like last Thursday, when the Dow fell by more than 512 points, that might not be so far off.

ALL that is certain is that Wall Street’s take on profits seems to have done a 180-degree turn. Where once investors were looking at earnings as a way to gauge the health of the underlying economy, they’re now using the bad economic news to gauge when profits will drop, said Ben Inker, head of asset allocation at GMO, the asset management firm.

It seems as if “the weight of ugly economic data is causing people to worry about the sustainability of the growth we’ve had so far,” Mr. Inker said.

So far, there have been only slight revisions to third-quarter profit growth, said John Butters, senior earnings analyst at FactSet.

As of Friday, the consensus forecast was that the S. P. 500’s earnings would grow 15.8 percent in the third quarter. That’s off slightly from predictions of 16.7 percent third-quarter growth at the end of June, Mr. Butters said.

Jeffrey N. Kleintop, chief market strategist at LPL Financial, says he thinks that “the estimates are still too high.” While profits might still grow by double digits, he said, they won’t be the 16 or 17 percent gains built into many analysts’ estimates.

In the best-case situation, he said, one reason for slowing profit growth will be that margins may decline as some companies ramp up hiring.

The worst-case event, of course, is that the economy will worsen significantly, cutting into both sales and profits.

Michael Thompson, managing director for S. P. Valuation and Risk Strategies, which oversees Capital IQ, says there is no evidence yet that this worst-case scenario is working its way into the estimates.

But market strategists say it may take some time for bad domestic economic news to work its way into profit figures, simply because of the nature of the S. P. 500. For one thing, the index tracks large, globally oriented companies that generate nearly half of their sales and profits abroad.

And Mr. Thompson added that historically, “analysts have never been good at identifying the inflection points in the economy”— for instance, when recessions turn into expansions and vice versa.

So if the economy is indeed headed south, all bets are off when it comes to profits.

Paul J. Lim is a senior editor at Money magazine. E-mail: fund@nytimes.com.

Article source: http://feeds.nytimes.com/click.phdo?i=17d676d84320783a76da93358acc5449