Profits Take A Pounding. But Do Investors Care?

They're counting on a rebound in the second half

So you think declining profits should be a warning sign that the unstoppable U.S. economy may be coming to a screeching halt? Don't tell investors that. So far this year, they seem to find lower company earnings an exhilarating tonic. And the first quarter's results will give them another big gulp of this strange brew.

With 20% of the companies making up the Standard & Poor's 500-stock index reporting by Apr. 15, initial indications are that first-quarter profits rose an anemic 2% to 3%--compared with analysts' predictions in January of a healthy 10% jump and an actual 30% rise last year. Yet, on Apr. 15, as surprisingly lackluster reports from such highfliers as Compaq Computer, Time Warner, and Coca-Cola rolled in, the Dow Jones industrial average leaped more than 50 points to an all-time high of 9162. For the market, the weaker earnings--although significantly lower than analysts expected--were arriving on schedule, so all was O.K. After all, even Federal Reserve Chairman Alan Greenspan had predicted the weakness.

But are these lower profits really the result of the financial crisis in Asia--a welcome pause to cool the potentially overheating economy, before growth resumes in the second half? Or do they hint at some more significant chinks in the economy's armor, coming as they do at a time when U.S. consumer spending could hardly be more robust?

Indeed, there are troubling signs the profit crunch could get worse. In the wake of Intel Corp.'s report of 36% lower income, Cowen & Co. managing director Drew Peck hurried to reduce his 1998 and 1999 earnings estimates for the chipmaker after Intel warned its second quarter will be off as well. "There doesn't seem to be any hard evidence that things are going to rebound," Peck says. Other analysts slashed their full-year estimates for Eastman Kodak Co. after it disclosed a sharp 14% drop in consumer film sales. "We've had more warnings than normal from significant companies," says Charles L. Hill, director of research at First Call. "The $64,000 question is: Do we see a continuation of downward revisions and a broadening in the second quarter?"

"DON'T CARE." So far, Wall Street is clinging to a view of better times later this year. Consensus estimates for profits of companies in the S&P 500-stock index still call for a healthy 12.2% gain in third-quarter earnings and a strong 19.5% gain in the final period. As long as new money continues to flow into mutual funds and companies buy back stock at the current breakneck pace, the bull market could be sustained. After all, says H. Vernon Winters, chief investment officer for Mellon Bank Corp.'s Private Asset Management group, investors "just don't care that earnings are slowing down."

Shareholders in oil companies might be an exception. With crude oil selling for 31% less than a year ago, Big Oil's profits are expected to tumble 37% from year ago levels when first quarter results start coming in on Apr. 20., according to consensus estimates tabulated by First Call. Even drillers, the most flush part of the industry, are now tempering their outlook. "Right now, the [drilling] market is better than it has ever been," says C. Russell Luigs, CEO of offshore driller Global Marine Inc. "Looking into the future, you may see a little softening."

Meanwhile, analysts are slashing estimates for technology companies, long the markets' little engines that could. First Call's second-quarter profit outlook for these companies has been slashed to a 1% gain, from January estimates of increases of 15%. Another warning sign: Cyclical industries such as paper, chemicals, and metals, are expected to see earnings actually drop 1% this quarter.

Economists see profits continuing to be squeezed between a flood of low-cost imports and rising labor costs. Some economists, such as James O'Sullivan at J.P. Morgan & Co., now expect gross domestic product, which grew 4% in the first quarter, to increase by only 1% in the third and fourth. "If you look at corporate profits, there is a lot more than Asia going on," O'Sullivan says.

FED JITTERS. And now, there are jitters about a change of heart at the Federal Reserve. Salomon Smith Barney Inc. economist David Hensley says he is beginning to worry that rather than cutting rates this year because of the Asian financial crisis, the Fed could actually raise rates because of unstoppable consumer demand. An increase in unemployment or a drop in the market could prevent that, but despite continuing downsizing by major companies the unemployment rate seems stubbornly low and the market stubbornly high.

Of course, this is a stock market that continues to defy the rules. So despite profit margin pressures, rising wage costs, and competition from imports, stocks could continue to float on a sea of liquidity. Whether it's investors padding retirement plans or corporate chiefs boosting buybacks, stocks are still the best game in town.

Before it's here, it's on the Bloomberg Terminal. LEARN MORE