Sure, Profits Are On The Rise, But...

Corporate profits are on the march--if you believe what brokerage-house analysts have to say. Analysts predict that earnings of companies in the Standard & Poor's 500-stock index will leap 18% in the second quarter alone--the biggest upswing in the past 10 fiscal quarters. And their prognostications for the year are equally glowing, averaging a 35% profit rise over 1992. If you believe the profit prophets, earnings will replace lower interest rates as the engine driving the stock market upward in the months ahead.

But the picture isn't quite as cheery as it seems at first blush. Yes, corporate belt-tightening and productivity gains have led to strong growth in profits--but much of the strength comes in comparison to 1991, which was a decidedly crummy year for corporate earnings. And even the most upbeat analysts are ratcheting back their second-quarter earnings predictions in virtually every sector (chart). That may foreshadow a spate of negative earnings surprises, particularly if the economy sours. "People are betting on a significant earnings turnaround," notes Michael L. Schonberg, chief investment strategist for UBS Asset Management. "But if the economy is disappointing, you could wind up with a year like 1990"--which was a down year for the market.

Probably the most ominous profit indicator is the gauge of analyst-estimate revisions. When analyst upgrades rise and downgrades decline, it's often a sign that investors are in for pleasant surprises when companies actually announce their earnings. Likewise, a trend toward more earnings downgrades is often a sign of bad news. By this barometer, the trend has been decidedly downbeat in recent weeks. According to Zacks Investment Research, a Chicago-based company that tracks earnings predictions, in the 30 days preceding June 26, upgrades accounted for a mere 37% of 1992 fiscal year estimate revisions for the stocks inthe S&P 500. The ratio of upgrades on May 8 was 47%.

ONE PLACE TO GO? The revisions in mid-May were skewed by upbeat earnings news in the first quarter. "Analysts got a little overly optimistic and then started hedging back their estimates for the second quarter," notes Benjamin Zacks, an executive vice-president of the company. Still, the trend toward increasing downgrades does not bode well for earnings in the months ahead.

Another sobering trend is analysts' tendency to revise downward only their second-quarter figures, leaving their third- and fourth-quarter earnings estimates alone. So if the economy does not stage a solid recovery later in the year, earnings will not rise as predicted, and stocks will have one place to go. Down. "I think expectations are awfully high overall," notes Melissa Brown, chief of quantitative research at Prudential Securities Inc. "If you look at top-down estimates by economists, the growth in earnings will be only 7% to 8% this year"--one-quarter of the rate predicted by analysts who look at individual company earnings. That could be a sign of excessive optimism--or, to put it another way, inadequate pessimism by the analysts now downgrading their estimates.

A glance at the Zacks charts shows where the potential trouble lies. Consumer cyclicals--including airlines and high-flying auto stocks--are among the most vulnerable. Likewise, basic materials companies--steel and chemical--are turning sour, as are capital-goods makers such as machinery and electrical-equipment manufacturers and high-technology companies, including the biotech companies that were the market leaders throughout 1991.

Only energy companies are seriously bucking the trend. But that hardly makes the profit picture look much better for the rest of the economy. Any sustained profit gain for the oil companies would come from an increase in crude oil and natural gas prices. And higher energy prices would mean inflation, higher costs--and curdled profits everywhere else.

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