Earnings Likely to Be Strong This Year But Not Match 2010

Despite a housing market that has yet to recover and unemployment showing only gradual improvement, Goldman Sachs believes corporate profits are set to soar this year.

Traders work in the ten-year U.S. Treasury Note options pit at the Chicago Board of Trade in Chicago, Illinois, U.S.
Daniel Acker | Bloomberg | Getty Images
Traders work in the ten-year U.S. Treasury Note options pit at the Chicago Board of Trade in Chicago, Illinois, U.S.

Goldman chief economist Jan Hatzius predicted this week that earnings will jump 25 percent in 2011—well above consensus estimates, though not as high as the fat 38 percent gains last year for companies making up the Standard & Poor's 500 index.

The forecast comes as investors await the kickoff for earnings season Monday, when Dow component Alcoa reports after the closing bell.

"The key theme of our economic outlook this year is that the US economy has plenty of room to grow," Hatzius wrote in a research note for clients. "The combination of strong GDP growth and a large output gap is also likely to produce big gains in corporate profits."

Other experts are significantly less buoyant than the Goldman forecast even while accepting the notion that the recovery story should continue through the year.

Citigroup , for instance, has a target of 12.5 percent S&P 500 profit gain for the year, based somewhat on slack in the economy along with the notion that margins have room to run and with companies expected to initiate $3 billion worth of share buybacks.

"Margins have yet to peak and we think revenues will be stronger, with a margin peak in 2011 and 2012," said Citi economist Steven Whiting. "Profit gains will still be higher, but not at the rate of the snapback pace of 2010."

For the most part, analysts have been waiting to see whether companies can begin a sustained period of revenue growth that does not merely rely on cost-cutting. Consensus in pure revenue growth for the year is around 6 percent, which is solid but perhaps unlikely to drive profits to the level of Goldman's' predictions.

Should that change and Goldman's models prove correct, it likely would recast the already-optimistic views for the stock market in 2011as well.

"[A]nalysts will have to hear real confidence from managements regarding topline growth during the upcoming earnings season in order to move off this range, and this is THE central catalyst for further stock market price appreciation," Nicholas Colas, chief market strategist at BNY ConvergEx, wrote in an analysis for clients.

Goldman's figures are based on historical trends of what happens when GDP registers year-over-year gains, as well as when the output gap—the difference between full capacity and the amount the economy actually generates—is as wide as projections anticipate.

"These projections are driven mostly by the large output gap, which historically tends to foreshadow a rising profit share of GDP," Hatzius wrote. "Eventually the pendulum is likely to swing back toward a higher labor income share, but probably not until the output gap has shrunk substantially and, in particular, unemployment is again much closer to normal levels."

It is the continuing high level of unemployment that has some market pros worried that projections for big corporate profits are overblown.

The current trend of companies doing more with less has reached its peak and is no longer feasible if companies want to achieve real growth, said Jeff Kleintop, chief market strategist at LPL Financial in Boston.

"This just speaks to an underlying bunker mentality that still seems to be present in corporate America," Kleintop said. "This is going to begin to limit revenue gains. Businesses have squeezed everything they can from their workers."

Still, optimists are hoping that the recent string of positive economic readings—Friday's middling nonfarm payrolls report aside—are pointing to sustained company profits ahead.

"What was nice about the last couple of quarters is you not only saw companies beat expectations on the bottom line, but also saw them beat revenue expectations on the top line," said Charles Schwab chief investment strategist Liz Ann Sonders. "It no only becomes more of a top-line story than it has been, it will be a testament to the strength of the overall economy."