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Earnings Look Strong Now, But Growth May Not Last

Caroline Purser | Getty Images

As investors prepare for the beginning of earnings season, two threats are lurking in the shadows: Toppy corporate profit margins and the threat to a consumer just showing signs of recovery.

Should either specter emerge from the dark it could cast a scary pall over how strong growth will be in coming quarters.

First, margins: Analysts such as Doug Cliggott at Credit Suisse and Nick Colas at ConvergEx believe profit margins and revenue growth, respectively, are showing signs of tiring and that consequently could hit future expectations.

In analysis released Monday, Colas, the chief market strategist at New York-based ConvergEx, warns that revenue expectations are “dangerously near the ‘Tipping Point’ of 2-3% revenue growth where most companies have trouble showing significant earnings leverage.”

This would be a significant trend in that investors are just getting used to the notion that companies have begun to shed the practice of beating earnings expectations on simple cost-cutting and now are hitting an actual growth period.

In the fourth quarter of 2010, about 70 percent of all companies in the broad-based Standard & Poor’s 500 topped profit expectations. The collective beat was 6.0 percent, with the leaders in the utilities, financials and information technology sectors, according to Capital IQ.

Analysts are expecting similar numbers for the first quarter, though a sector rotation likely will be in play as consumers change their habits and new regulatory standards put a crimp in financials.

However, despite the apparent resurgence in consumer health and the ability of companies to return more or less to normal, revenue growth expectations are fairly muted.

As Colas points out, if you exclude energy giants ExxonMobil and Chevron along with Caterpillar—the three stocks are collectively “a derivative play on commodity prices”—revenue growth is expected to be just 6.4 percent in the first quarter and 6.8 and 7.5 percent in the next two quarters, according to sell-side analyst projections.

While those numbers don't look bad either, Colas points out that they could fade into the aforementioned "tipping point" if the headwinds intensify. Specifically, he notes that big companies such as General Electric , Bank of America and four others are likely show revenue decreases, while consumer benchmarks such as Wal-Mart and Procter & Gamble are likely to be below-average in revenue growth. (GE is the minority owner of CNBC.com.)

Growth, then, faces three headwinds, according to Colas: Less accommodative monetary policy; waning investor interest in stocks, as reflected through exchange volume; and demand for greater revenue growth.

“Stocks must sing for their supper in the next few weeks of earnings reports,” Colas warns, “and it had better be a pretty peppy tune.”

Similarly, Credit Suisse economist Cliggott cautioned recently that corporate profit margins have been stuck at 12.7 percent in the past two quarters, a good number in itself but, if unimproved, feeds into a trend that has proven a sticky indicator for stock growth.

“In the last 10-12 years, the profit share of US national income and S&P 500 operating earnings per share (EPS) have been highly correlated,” he wrote in a note to clients. “So a peak in S&P 500 operating EPS may also not be too far out in time.”

Second, threats to the consumer, which come as surging commodity prices threaten to derail signs that people are spending money again.

While some companies, particularly on the energy side, will benefit from soaring energy costs, worries that $110 oil and $4 a gallon gas will stop the consumer in its tracks and hamper profit margins also weigh on earnings momentum.

“To the degree a weaker dollar pushes crude higher, the predominantly multinational companies of the Dow at least receive the benefit of a weaker greenback when it comes to financial results,” Colas writes. “But the term ‘demand destruction’ in the energy sector applies to total economic demand as much as it does to lower consumption of oil and gas.”

To be sure, though, there’s an optimistic view.

Michael Thompson, managing director of valuation and risk strategies at S&P, points out that despite pressures on the consumer through both rising food and energy prices, defensive stocks have been less in favor than their cyclical counterparts. He points to the recent better-than-expected retail sales numbers as evidence that the consumer may withstand higher prices.

“Intuition is not playing out very well in this quarter,” he said in an interview with CNBC. “Despite higher oil prices…we’ve actually seen consumer discretionary that’s going to post a 10 percent gain over the same quarter last year.”

Indeed, the resilience of the stock market could outweigh any discouraging earnings headwinds.

“There are a lot of things here that you would think are negative backdrops for equities, but honestly they don’t seem to be making much difference to portfolio managers,” said Rick Bensignor, chief market strategist at Dahlman Rose. “Very little seems to truly inspire fear these days other than missing the up move. That is just backwards thinking, but it is ruling the day.”

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