No Quarter for Investors?

Expect a second-quarter earnings slowdown to cast a pall, bringing an end to the much-liked string of double-digit increases

By Amey Stone

Get ready for single-digit earnings growth. The stock market surged on June 28, as the price of crude oil slipped back from the spooky $60-a-barrel level and new consumer confidence figures showed more improvement than expected. But investors are ignoring -- for now -- the fact that the second quarter is about to wrap up, and year-over-year earnings-growth comparisons are expected to show a sharp drop.

Standard & Poor's predicts second-quarter operating profits will grow just 7.8% over the same three-month period in 2004, ending a 12-quarter streak of double-digit gains that dates back to June, 2002. First-quarter earnings grew 13% over the same quarter in 2004, and 2004's fourth-quarter earnings were up a smashing 21% over the prior year, according to data from S&P in New York.

"Most investors will not be surprised at the slowdown," says Howard Silverblatt, equity market analyst at S&P. That's because pundits have been predicting an earnings deceleration for most of the past year. The shocker is the intensity of the drop-off. "They aren't going to get that double-digit number they had hoped for."

TECH SIGNALS.

 Things would be even worse if not for recent upward earnings revisions in the energy sector that helped boost the quarter's overall outlook in recent weeks, says John Butters, research analyst at Thomson Financial. Second-quarter earnings for the energy sector -- the strongest in S&P's rankings -- are expected to grow 29% over the prior year, up from 25% two weeks ago. The materials sector should perform second-best, with 23% growth.

Tech earnings will be the main focus of investors for this quarter's earnings season, says Nick Colas, director of Research at Rochdale Securities. That sector has already rallied, thanks to positive mid-quarter updates from both Intel (INTC ) and Texas Instruments (TXN ). "Technology isn't as tied to energy prices, and their mid-quarter updates gave people some confidence that things are O.K.," he says.

The worst-performing sector in S&P's rankings is likely to be consumer discretionary -- home to the downtrodden auto makers and auto-parts manufacturers. Consumer-discretionary earnings are expected to decline 4 percentage points (it's the only negative sector). But subtract the six auto-related companies in that sector and growth would climb 13%, says Butters, mainly due to the strength of retailers.

MISLEADING INDICATORS.

 It's still too early to tell whether earnings will come in worse than analysts are forecasting. So-called "preannouncement season" -- when companies that didn't meet analysts' earnings estimates for the quarter start 'fessing up -- is just about to kick off, say investment strategists. FedEx (FDX ) disappointed investors on June 23 when it warned that earnings in the coming quarter would be weaker than expected due to higher oil prices. But that's the only major company to disappoint recently, hardly making a trend.

Many investors made the mistake last quarter of putting too much emphasis on a few high-profile disappointments early in the quarter and missed out on the gains that followed when most companies exceeded estimates, says Silverblatt.

Most investors aren't focused on earnings season yet, say strategists. Instead, they're concentrated on the strength of the economy and whether the Federal Reserve will continue to raise short-term interest rates to keep inflation at bay. "Right now, we're all just grasping at straws and hoping to get some color on where the economy stands," says Colas. Most investors won't even begin to think about second-quarter earnings until after the Fed policymakers meet on June 29 and 30. "From now until Thursday, it's all about [Fed Chairman] Alan [Greenspan]," says Colas.

BALLPARK NUMBER.

 Trip Jones, managing director of sales at SunGard Institutional Brokerage, believes the Fed will raise rates a quarter-point each at scheduled June and August meetings and then signal that it's finished. He expects stocks to rally sharply as soon as investors realize the tightening cycle is coming to a close. "There will be all this pent-up excitement when people realize it's over," he says.

Of course, Jones concedes, that's assuming second-quarter earnings aren't much worse than investors are currently expecting. "As long as earnings are in the general ballpark, the market is going to be in good shape," he says. Jones and other bullish investors are also assuming investors are prepared for a slowdown in earnings growth that's clearly in the cards.

Stone is a senior writer for BusinessWeek Online in New York

Edited by Beth Belton

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