By Eric Wahlgren Corporate profits appear to be waking up from their Rip Van Winkle curse of the last few years. The third-quarter earnings season has opened with a bang: 64% of companies reporting so far have exceeded analysts' estimates. Early results suggest that Corporate America is on track to boost profits by as much as 20% this quarter, First Call says. That would make it the best three months since the second quarter of 2000, when earnings jumped 21%.
Of course, these days companies manage earnings precisely to blow past Wall Street's expectations, a widely known fact that diminishes the wow factor. Little wonder the big lift in profits hasn't ignited investors. The Standard & Poor's 500-stock index is up less than 1% since the reporting season unofficially began on Oct. 7. In fact, that benchmark is barely ahead of where it was a month ago, even though profits of S&P 500 companies are expected to rise 17.2% in 2003 vs. an expected 12.9% in 2004, according to First Call.
CLOSE-MOUTHED. It's going to take more than better-than-expected earnings to really put this market into overdrive, investing pros say. Stocks have already rallied fast and hard in anticipation of an impressive third quarter. "The market has had a big run," says Crit Thomas, director of Growth Equity Investment for the Armada Funds in Cleveland. "I'm not sure the [price-earnings] multiples can expand much more."
The S&P 500 is trading at 19.2 times expected 2003 earnings, pricier than its historical average p-e of about 17. For those multiples to stretch any further, "We have to see some of the companies say their business prospects are good for the fall and beyond," says Sam Lieber, president of Alpine Funds in Purchase, N.Y. And investors aren't likely to be impressed with more earnings gains that result from renewed cost-cutting. Don't expect their excitement to be sparked until they see profits that have come from a genuine pickup in demand.
Complicating matters is the fact that companies aren't blabbing to Wall Street and investors like they used to. Companies might be able to communicate more about the quality and make-up of their earnings, but in an environment still recovering from the scandals and missteps of the past few years, executives are leery, market experts say. "Companies are less willing to stick their necks out because they don't want to appear like they're manipulating earnings," says Joseph Lisanti, editor-in-chief of S&P's financial newsletter The Outlook. (Like BusinessWeek Online and BusinessWeek, S&P is owned by The McGraw-Hill Companies.)
POTENTIAL CATALYST. Bottom line: Wall Street wants to see signs of real demand increasing, and it wants to make sure that's happening in manufacturing. Any signals of improving performance from industrial conglomerates could provide a psychological lift to the market. "It's America," Thomas says. "You have to get the industrial side moving to keep the rally going."
The recent lowered fourth-quarter earnings targets from General Electric (GE) didn't help the cause. Although GE is primarily a finance company that also makes appliances and jet engines, it's still perceived as an industrial bellwether. If what happened at GE repeats itself across the industrial sector, "that would put a cloud over the market," Thomas says.
Any evidence that capital spending is on the rise would be a potential catalyst for a market that has already priced in a recovery but grown tired of waiting for it to gain momentum. Businesses are starting to buy new computers, servers, and other big-ticket items. The question remains at what pace. Thanks to a forecasted yearend surge, equipment spending is expected to show an increase of 4% in 2003, says Mike Englund, chief economist for New York-based economic research firm MMS. In 2004, MMS sees that number 14%.
HIRING NEEDED. The increase, however may still largely depend on how well consumers, which account for 70% of the economy, hold up. "If corporations see consumers pulling back, they aren't going to make investments in expanded capacity," Lisanti says. Investors crave hints that consumers haven't stopped feeling upbeat about the future. In particular, the market is looking for a rebound in the Consumer Confidence Index, put out by the Conference Board, after the gauge unexpectedly nosedived in September. The report on October is due out Oct. 28. "If consumers start getting worried again and they stop spending, it puts everything at risk," says Lisanti.
What consumers need, the economists say, is confirmation that the crummy job market is improving. A recent report that the number of Americans filing initial claims for unemployment insurance fell to its lowest weekly level -- 382,000 -- in eight months was encouraging. "If the better employment numbers become trends, that would be positive for the market," says Lieber. He adds that initial unemployment claims would have to decline to the 250,000-a-week level "to feel we really have job creation going on."
To be sure, investors will take the market higher in the "absence of anything really negative," predicts A. C. Moore, chief investment strategist with Dunvegan Associates in Santa Barbara, Calif. That means no dreadful earnings warning from bellwether companies and no major deterioration of the already-shaky situation in Iraq.
Others agree. Investors are itching to put their money somewhere as they've been hoarding cash at record levels, says investing pro Louis Navellier, chief investment officer of Reno-based Navellier Management. "Cash is going to come back into the market," he says Navellier (for a Q&A with Navellier, see "I See Stocks Going Higher").
WHERE'S THE BEEF? As Moore and others see it, for now the "path of least resistance is up." With the S&P 500's dividend yield alone at 1.7%, stocks are more appealing investments than short-term bonds, which are yielding about 1%, he says. "Looking at returns, the alternatives to stocks are not very attractive," Moore says.
Still, investors looking for a big run-up similar to what happened earlier this year may be due for a disappointing fourth quarter. A sideways-moving market is better than one headed south. But this market has run higher on sizzle, now it wants some steak. Wahlgren covers markets for BusinessWeek Online in New York