The Earnings Boom That Can't Budge InvestorsJeffrey M. Laderman
Few people watch corporate profits as closely as Ben Zacks of Zacks Investment Research, which tracks earnings forecasts on some 4,000 companies and compares them with actual results. And the Chicagoan certainly likes what he's seeing these days. Since the third-quarter earnings started rolling in a few weeks ago, the numbers, says Zacks, "have been spectacular." Not only are profits weighing in 27.3% higher than last year but, even more noteworthy, 56% of the companies reporting logged profits that were higher than expected--twice the percentage of companies that let investors down.
Such a surge in profits should be giving the stock market a big lift, since companies that ring up earnings surprises tend to repeat such behavior for several quarters, if not longer. "Fourth-quarter earnings should be spectacular, too," says Carmine J. Grigoli, chief U.S. portfolio strategist for Nomura Research Institute Ltd. And even if the economy does slow somewhat next year, companies have so streamlined their operations that earnings will still look sharp. "This is the best environment for corporate profits in two decades," says Grigoli.
"BAFFLED." Yet, the stock market is struggling. During October, the Dow Jones industrial average is barely in the black, and the broader Standard & Poor's 500-stock index is about even. The reason: Just days after earnings reports started to hit the Street, interest rates resumed their yearlong climb. On Oct. 24, the yield on the benchmark long-term U.S. Treasury bond hit 8%, its highest level in more than two years. Short-term interest rates are now at three-year highs.
Higher rates are never a positive for stocks, but they don't necessarily have to be a depressant, especially when profits are so surprisingly robust. "I'm baffled by the market's reaction to earnings," says Michelle R. Clayman, chief investment officer at New Amsterdam Partners, a New York money-management firm. Clayman suspects investors are dismissing the earnings as peak profits for the economic cycle and looking toward a recession in 1996--an outlook that she does not share.
Profit watchers say there are solid reasons for the boomlet on the bottom line: stronger revenue growth, lower overhead, healthier balance sheets, and much-improved productivity. In addition, the weaker U.S. dollar makes American goods cheaper and more competitive. In addition, profits earned in other currencies become more valuable when translated back into dollars.
Important contributors to the profit boom are producers of raw materials and intermediate goods--such as paper, copper, and steel--which, for the first time in seven years, have been able to raise prices and make them stick. Not surprisingly, 67% of basic-material companies and 61% of the industrial concerns reporting thus far have delivered earnings that have been better than expected, according to Zacks.
Ironically, that is one reason the bond market is declining and interest rates are rising. If companies are prospering by raising prices, won't that eventually trigger inflation? So far, those price increases have not found their way to the consumer--and inflation at the consumer's level remains tepid. But many on Wall Street believe the strong profits will lead to higher inflation and prompt the Federal Reserve to continue to hike interest rates.
The alternative view of the profit picture is more sanguine: U.S. companies know how to make money in the 1990s. They're increasing productivity, forcing unit labor costs down. "We've figured out how to make the same number of widgets with 30% fewer workers, and that's key to inflation," says H. "Woody" Brock, president of Strategic Economic Decisions, a financial consulting firm in Menlo Park, Calif. "If you're watching commodity prices, you're looking at the wrong thing. Materials are only 12.5% of costs."
SHORT DROP. If Brock's analysis is right, interest rates should ease--and give equity investors a reason to rally. To get stocks rolling again, it's not necessary to retrace the more than two-percentage-point rise in long-term yields over the past 12 months. John B. Neff, who runs the $11.6 billion Vanguard/Windsor Fund, thinks long-term rates need only drop to the 7.25% neighborhood to get stocks back on track. "There's not a lot of excesses in the economy and thus no need for a recession," says Neff. "There's no reason we can't have good, solid, moderate growth for another three years."
An easing of interest rates can't come soon enough for investors such as Rodney L. Linafelter of Berger Associates, who runs the $2.2 billion Berger 100 Fund. The Berger staff concentrates on ferreting out companies that have good earnings prospects, and indeed, the average earnings-per-share growth for the companies in the fund so far this year is 60%. Yet because the market is still thinking about rates and not earnings, the fund is down more than 5%. "Institutions and the investing public are vastly underestimating the earnings power of Corporate America," says Linafelter. In a little less threatening interest-rate environment, they're more likely to appreciate it.
Corporate Profits Are Surging... Third-quarter profit growth for 4,000 companies 27.3% Companies with higher than expected earnings 56% Companies with lower than expected earnings 28% Companies meeting earnings forecasts 16% * ESTIMATES DATA: ZACKS INVESTMENT RESEARCH