Profit Lag May Dampen Stock Rally

Graham Bowley

In this less-than-sparkling economy, Americans have at least been able to look to the rising stock market and corporate America’s robust profits as two bright spots, but even these may now be dimming.

Erik Snyder | Getty Images

Stocks have seesawed much of this year as investors worried about higher commodity prices, the Japanese tsunami’s impact on global supply lines and Europe’s debt crisis.

Now a string of second-quarter corporate earnings announcements due over the next few weeks could confirm that companies are beginning to have a harder time.

Higher gas prices are soaking up already weak consumer spending, banks are struggling and labor costs may be starting to pick up, squeezing business’s profit margins meaningfully for the first time.

All of that could spell more trouble for the stock market. Stocks rallied sharply last week after the Greek Parliament passed austerity measures. But some analysts question how long the rally will last. If it does not endure, it could complicate the economic picture as these two pistons of the already sputtering economy, profits and the stock market, fire less powerfully.

“For the first time in this economic cycle, there is going to be a fair number of disappointments,” said Doug Cliggott, an analyst at Credit Suisse, referring to the earnings reports. “The economy is going to be without those drivers.”

Europe’s debt crisis may be far from over. Standard & Poor’s, the credit rating agency, said on Monday that a plan promoted by France for French and German banks to roll over their large holdings of Greek government debt would in fact amount to a default by Greece, raising questions about how the indebted nation could qualify for a much-needed second bailout.

On the other hand, some analysts are predicting a relatively rosy United States profits season that belies the continued grim domestic economic news. They think companies will do well, since consumers have made some progress in trimming their debt and may be prepared to start spending again. Energy prices have at least stopped going up.

“We are going to get good news out of the corporate sector and markets can move higher,” said Jack Caffrey, equity strategist at J.P. Morgan.

The 5.4 percent jump in the Dow Jones industrial average last week, in one of its strongest weeks in two years, seemed to support that optimism.

Already some investment professionals are predicting that the Standard & Poor’s 500-stock index may be back at 1,400 or higher by year-end, if not sooner; it closed at 1,339.67 on Friday. Some are making comparisons with last year, when after a few rocky months markets touched lows in the first week of July—and soared for most of the rest of the year.

“With the exception of the bust of late 2008/early 2009, U.S. stocks are now the cheapest they have been in 20 years,” Steve Sjuggerud, editor of True Wealth, an investment newsletter, wrote in June. He forecasts that the S.&P. 500 will be back at 1,450 by year’s end.

But the bears believe that optimism is overdone.

In addition to Europe’s troubles, they point to continued poor U.S. economic numbers.

Last month the Federal Reserve revised its expectations for economic growth down to a range of 2.7 percent to 2.9 percent, from 3.1 percent to 3.3 percent in April. Many independent economists are more pessimistic. There is a risk that the economy will struggle further from budget and job cuts at the local and state levels, and even at the federal level, depending on the debate about the debt ceiling.

A further drag could be the end of the Fed’s $600 billion asset buying program, which had been buoying stocks since last fall.

Companies had been socking away profits by, among other things, keeping down labor costs and increasing productivity, but their profit margins may now be squeezed as both their unit wage costs and investment spending begin to rise.

Credit Suisse expects the stock market to end the year below its current level, with the S.&P. 500 at about 1,275.

“Analysts are expecting blockbuster earnings numbers, but I am not so sure,” said Jeffrey Kleintop, chief market strategist at LPL Financial. “We have a defensive strategy.”

Mr. Kleintop said corporate leaders would most likely reduce their earnings guidance for the second half of this year when they announce their results for the second quarter.

The early earnings reports have been mixed. FedEx reported net income up 33 percent for its fourth quarter, which ended May 31, compared with the same quarter a year earlier—heartening the bulls who see the company as a good bellwether for the rest of the economy.

Frederick W. Smith, FedEx’s chairman, said in a conference call with analysts that the economy had been through a brief soft patch.

“We believe that the near-term softness in the economy will be temporary as fuel prices have retreated from their April highs and the Japanese economy recovers,” he said. “Going forward we see stronger economic growth.”

Nike reported strong gains in sales, especially in the key North America and China regions. But Oracle’s earnings for the last quarter disappointed markets with subdued demand for computer hardware.

Other companies have provided some whispers about what might be coming by issuing preannouncements that provide guidance on whether their results will be better or worse than they had previously signaled.

According to Thomson Reuters, out of a total of 125 companies in the S&P 500 providing guidance through preannouncements, 81 were negative as of the end of June and 33 positive—a higher negative-to-positive ratio than at the same time last year.

Sam Stovall, chief investment strategist at Standard & Poor’s, said the consensus among Wall Street analysts was for annual growth in operating earnings among S&P 500 companies of 15.6 percent in the second quarter, led by energy and materials companies.

This is strong growth but still represents a slowdown from the annual rate of 19.7 percent in the first quarter and 37.7 percent in the fourth quarter. In the whole of last year, operating earnings advanced 37.9 percent.

“We feel the economy has likely downshifted because of a combination of Japan and commodity prices—it is a fragile economy,” said Mr. Stovall, who is forecasting the S.& P. 500 index to be around 1,350 by year’s end.

The reporting season will begin in earnest with results from the large Wall Street banks. They are likely to reveal an especially bruising quarter because of the choppy markets and subdued borrowing by households and companies.

Analysts have been rushing to take down their estimates. John McDonald, a Sanford C. Bernstein analyst, said both stock and bond trading revenue for the biggest Wall Street banks could be off about 20 percent from a year ago.

More traditional banking did not fare much better. New regulations have ratcheted up expenses and are also starting to chip away at once-lucrative income streams, like overdraft charges on checking accounts and credit-card penalty fees.

The banks are also bracing for a multibillion-dollar hit on the fees they collect from debit card transactions, despite some relief when the Federal Reserve released its final rules last week.

Higher capital requirements, meanwhile, could put pressure on some banks to lighten their balance sheets.

The fragile economy has made consumers and businesses more hesitant to take out new loans. That, along with low interest rates, has hurt lending profits. Mortgage income is expected to be sharply lower than a year ago, when a surge in refinancings helped prop up the banks’ results.

The bulls should get a boost in the middle of the reporting season when big industrial companies that have large sales abroad are likely to show continued strong growth, helped by fast-growing emerging economies.

“The industrial sector is holding together well, supported by the emerging economies,” said Nick Kalivas of MF Global. “I don’t detect any material slowdown.”

The strength of the euro against the dollar compared with a year ago should also help companies with large revenues coming from Europe.

But at the close of the reporting season, retail companies may once again underscore the continued depressed state of the American consumer—and provide a downward pull on the market.

According to Mr. Kleintop of LPL Financial, the bulls and the bears will eventually have to compromise.

“In the end these two camps will come together,” he said.