Earnings Will Be Bad, But What's Ahead Matters More

The worst kept-secret on Wall Street is that this quarter's earnings season will be disastrous. The best-kept secret is what lies beyond the carnage.


It's what's past the horizon that pre-occupies market-watchers these days, as investors look for some daylight to crack through the recession storm.

"The biggest question for everyone is, have the share prices already discounted not the fourth quarter (of 2008) but the second quarter and third quarter of this year?" says Quincy Krosby, chief investment strategist at The Hartford. "Obviously, everyone is going to focus on guidance. The question is, how much guidance does anyone have at this stage?"

But trying to divine some critical post-recession truths could be easier said than done.

Outlooks are likely to paint an equally grim picture as earnings, though companies could provide clues as to what to expect in the later part of the year when the worst of the recession is expected to pass.

Specifically, investors will be looking to see what President-elect Barack Obama has in store in terms of tax policy and economic stimulus.

"What we expect is choppiness and headline risk, but also headline gains," Krosby says. "We're hoping there's a positive surprise from the stimulus package in terms of tax cuts for corporations. Because there's so much unknown, it's a difficult haul."

As for earnings reports, the two primary areas Wall Street will be looking at are the employment picture and the outlook for credit.

If bellwether companies report that there won't be major layoffs, and CEOs start talking about being able to raise capital after a year in which money was as scarce as hope, that could lead to optimism and prevent a major earnings-season selloff.

Earnings have been a mixed bag in the first week, with large banks on tap next week after Citigroup reported earnings Friday that weren't quite as bad as some had expected.

"What the equity markets on a macro level want is some clarity on liquidity, and end this sort of deer-in-the-headlights look that seems to be permeating every aspect of business," says Lee Schultheis, chief investment strategist and portfolio manager at AIP Funds in Harrison, N.Y. "I doubt there's been a situation in most everyone's collective market history where they felt less certainty on what general conditions will be like."

And with the uncertainty, investors are likely to hedge their bets with cautious equity plays and a continued preference for corporate debt rather than stock.

Cyclical stocks, such as energy, materials and consumer discretionary should be popular, as will some hidden gems in the beer and tobacco industries--sectors that tend to benefit in economic hard times.

Overall, though, investors are likely to be cautious.

"Earnings continue to get worse yet the stock market itself isn't. Some are taking that as a positive sign that the markets are looking forward to the recovery and that may well indeed be the case," says Chip Hanlon, president of Delta Global Advisors, in Huntington Beach, Calif.

"The other way to look at is, is the stock market kidding itself that the recovery will be here earlier than it really will? ... I just think that investors are going to end up being surprised that as bad as things are in the fourth quarter they are likely to be worse through the first quarter and through the year."

Pockets of Strength

Pockets of Strength

With all of the bad news permeating the markets, investors will be looking for worst-case scenarios and placing their bets from there.

"I do not believe we will see a sustained rally in the market until people feel like they can call with reasonable certainly both the amplitude of the earnings drop and somewhat the timing of it," says Uri Landesman, head of global growth strategies at ING Investment Management in New York. "What investors are basically looking for is what is the worst we can get in S&P earnings and let's put an 18 multiple on that, and that will be the low end for stocks."

For Investors

Cyclical stocks will be popular this year, says Landesman, who manages more than $2.5 billion at ING. Energy, consumer discretionary and materials stocks should do well, while Landesman is underweighting financials, consumer staples, health care and utilities.

"I have heard it opined that at least in the short term (the S&P will be in) an 800 to 1,000 trading range. I think that's very possible," he says. "Right now, I'm still hoping by the last quarter of the year then we take out that 1,000 top and make up a number where we end the year--1,105, 1,165, 1,200--I'd like to think we can be somewhere near there."

Those types of numbers have traction among other analysts, who believe the best returns will come in those areas that capitalize on the downturn, with the notion that stocks will recover ahead of the economy.

Those trends should be reflected in the earnings of companies across various sectors.

"As the economy declines there's going to be a return to increased beer consumption and away from spirits," says Steven Roge, portfolio manger at the Roge Partners Fund. "For the past couple of years spirits outpaced beer consumption. I think a lot of it had to do with the economic expansion. As the economy contracts, people are going to look for a cheaper alternative."

Companies such as Boston Beer should do well in such an environment, Roge says. He also cites Molson Coors in the space, while also asserting that as more people will buy beer, they'll also be smoking while they're drinking.

Among those companies he advocates Philip Morris International.

Outside that area, Roge also is watching companies that should do well in the Obama White House, including software companies that will benefit from the planned infrastructure stimulus and the need for sound urban planning programs.

He cites Microsoft and Autodesk among two that should benefit.

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Also following economic plays, AIP's Schultheis says he'll be short on dental supply companies but long on pharmaceuticals, reasoning that people will put off optional work on their teeth but continue to buy prescription drugs they need.

At the same time, he says he wouldn't be short or long the market exclusively, instead focusing on pockets of strength and weaknesses for respective long and short positions.

"The overall environment can improve if the psychology improves," he says. "This is a stock picker's environment especially if you're able to be both ways. I don't know that it's a great stock-picker's environment if you're traditional long only."

"We're at least starting to make some gains," Schultheis adds. "I think confidence is coming back but it's coming back in increments, sort of like a lot of little baby steps."