On Wall St., a Big Split on Outlook
Amid all the grim economic data and a chorus of warnings of a fresh recession, one group on Wall Street has remained remarkably optimistic despite the dangers that may lie ahead — the research analysts who track individual companies.
Typically bullish in the best of times, this group has barely budged on its expectations for earnings in the second half of 2011, even as the economists and strategists at the big brokerage firms have steadily ratcheted down their forecasts for overall economic growth.
That disconnect could prove painful for investors. On Friday, shares of Hewlett-Packard were punished after the technology giant reported results below analysts’ projections and warned them to bring down future numbers. Earlier in the week, similar shortfalls caused shares of Dell and Urban Outfitters to sink.
The 17 percent drop in the Standard & Poor’s 500-stock index since late July suggests investors already suspect earnings growth may not be as robust as forecast when the summer began. But if more analysts start cutting their estimates in the coming weeks, that could provide yet another incentive for traders to sell.
Investors are clearly anxious. Stocks fell more than 4 percent last week as the wild swings on Wall Street continued, including a 419-point drop for the Dow Jones industrial average on Thursday.
“Absolutely, the numbers look too high to us,” said Doug Cliggott, a United States equity strategist at Credit Suisse. “In the last two or three weeks, we’ve had a slew of data showing our growth could be slowing a lot more than expected.”
All this means that September could be a make-or-break month for the stock market. “A lot of Wall Street folks come back after Labor Day and sharpen their pencils,” said Adam Parker, United States equity strategist at Morgan Stanley.
When they do return, they will have plenty of numbers to crunch that suggest a further slowdown is possible. On Friday, the Labor Department reported that unemployment rose in 28 states and the District of Columbia in July, while it fell in only nine states. A day earlier, the Federal Reserve Bank of Philadelphia announced that manufacturing activity in the mid-Atlantic region shrank sharply in August.
Traders will be closely watching a range of figures due out this week for more signs of a so-called double-dip recession. On Tuesday, the government is to report on sales of new homes for July, followed by a report on durable goods orders on Wednesday. Data on initial jobless claims and consumer sentiment in August will follow later in the week.
In spite of the lackluster economic numbers in recent weeks, analysts’ expectations for earnings growth of the typical company in the Standard & Poor’s 500-stock index have edged downward only slightly. The current consensus for the third quarter calls for 15.6 percent earnings growth, not far from the 17 percent analysts forecast on July 1, according to data compiled by Thomson Reuters.
In the fourth quarter, analysts expect growth of 17 percent, just 0.6 of a percentage point below where the projections were at the beginning of July.
By contrast, economists at the big brokerage houses have been busy slashing their projections for overall growth, with JPMorgan Chase weighing in on Friday while Morgan Stanley and Goldman Sachs trimmed their numbers the day before. JPMorgan now expects fourth-quarter economic growth to be 1 percent, down from an earlier projection of 2.5 percent. Morgan Stanley warned that the United States and Europe were “dangerously close to recession.”
While they may work for the same bank, analysts and economists don’t necessarily see eye to eye.
In the argot of Wall Street, broad economic growth projections are called top-down forecasts because they incorporate a wide range of macroeconomic factors, like manufacturing output and the unemployment rate.
That contrasts with the bottom-up estimates arrived at by tallying the earnings projections of analysts who follow individual companies. The two groups usually work independently — and can project different results.
The bright side
Often, critics say, company analysts are too slow to adjust what are characteristically more positive projections. Rather than act before bad news hits, analysts often wait for companies to lower their forecasts. That can blindside investors. For example, shares of Hewlett-Packard fell 20 percent on Friday and contributed to a 1.5 percent decline in the overall market.
“They are a bunch of lemmings and are impacted by their counterparts in the corporations they follow,” Douglas Kass, a hedge fund manager and founder of Seabreeze Partners in Palm Beach, Fla., said of company analysts. “They look at things in the rear-view mirror.”
To be sure, analysts seeking information are heavily dependent on the companies they cover, and those companies often wait until the last minute to disclose disappointing results. What is more, many executives at big companies go on vacation in the second half of August, making it harder to glean new data on factors like sales and income.
Despite the gloomy outlook in the United States and Europe, some positive factors could still prop up earnings in the third quarter, which ends Sept. 30.
For some multinational corporations, business has held up in developing markets in Latin America and Asia, while others are benefiting from stronger earnings overseas as a result of a weaker dollar. In addition, some manufacturing and technology companies may have already booked profits on orders locked in until the end of the year, so their income may not fall off until 2012.
Even so, in some sectors the numbers are dropping much faster than in others. With the downturn on Wall Street, along with new regulations and tighter lending margins, the consensus estimate for earnings growth at financial companies has dropped to 13.8 percent now from 15.6 percent on July 1, according to research compiled by Thomson Reuters.
Nevertheless, the financial sector remains vulnerable to disappointments, Mr. Parker of Morgan Stanley said, as do companies in the consumer discretionary category, which includes retailers, restaurants and apparel makers.
Analysts expect earnings for consumer discretionary companies to increase 19.5 percent in the third quarter, just a bit below the 20 percent gain they forecast on July 1. Mr. Parker said the risk of big disappointments was lower in sectors where expectations were not so aggressive, like utilities, health care and telecommunications services.
More reductions in top-down estimates of overall growth by Wall Street economists are expected this week, only heightening the likelihood that earnings projections will eventually have to come down, too.
“It’s hard to imagine that as people are ratcheting down economic expectations, everyone can keep these numbers where they are at,” said Tobias M. Levkovich, Citigroup’s chief United States equity strategist. “There is going to have to be some ratcheting down to match those economic forecasts.”