Stocks: A Slower Gain Is Better Than None

Don't look for miracles, but a surprise profit revival could give the market a nice lift

Despite the stock market's rebound from the summer lows, there's an unsettling element about it. True, the global financial crisis that precipitated the almost 20% plunge in the blue-chip averages seems to have receded. But even before the plunge, the growth rate of U.S. corporate profits, one of the principal engines of the long bull market, was slowing to a crawl and making the high valuations suspect. "When you look at the fundamentals today vs. June or July, they're worse," says Richard Bernstein, chief of quantitative research at Merrill Lynch & Co. "Earnings growth is negative. We're in a profits recession."

Does that mean the stock market is heading south? Not at all. The big surprise of the new year: Profits will be better than Bernstein and many others think and certainly a lot better than 1998, which is unlikely to show any growth over 1997.

That will translate into higher stock prices. Don't look for a reprise of the 30%-plus gains of 1995 and 1997, or even this year's 19.8% on the Standard & Poor's 500-stock index (through Dec. 15). True, the Dow Jones industrial average's 550-point pullback over the last few weeks--a product of profit worries and the impeachment showdown in Washington--makes Dow 10,000 a little more distant. Still, a modest 10% gain in the Dow next year would get it above 9700.

MAJOR BLOWUPS. The case for higher earnings starts with a close examination of 1998 profits. For instance, the three largest sectors of the S&P--finance, technology, and energy--each had a major blowup. Early in the year, technology earnings got slammed as companies worked down inventories and retooled for new products. The financial companies, mainly banks and brokerage firms, hemorrhaged in the third quarter. That was largely related to write-offs of Russian debt and bad hedge-fund loans. And profits in the energy industry evaporated as oil prices sank to the lowest level in 11 years. That's not all. The General Motors Corp. strike shaved about 1.2% from earnings, and the strong dollar that reigned from January through August put a crimp in the big multinationals that dominate the S&P 500.

Edward M. Kerschner, investment strategist at PaineWebber Inc., estimates that 40% to 45% of S&P earnings come from outside the U.S.

Now, consider 1999. Earnings are on the upswing in technology--one area where analysts are marking up forecasts. "You can get 25% earnings growth in the tech sector alone," says strategist Peter J. Canelo of Morgan Stanley Dean Witter, who says S&P earnings could log a 9% to 10% gain next year. Financial companies are always at the mercy of the markets, but one thing they won't have to do next year is write off this year's mess. With the stock market recovery, the renewed mergers-and-acquisitions boom, and the pickup in initial public offerings, their earnings should improve considerably.

Energy? No bright outlook there, but Kerschner estimates that if the rate of decline in energy prices is only half as severe as in 1998, it could add back 1.9 percentage points to S&P earnings. If that doesn't happen, there is an offset: Falling energy prices mean higher profits for airlines and truckers and more discretionary spending for consumers. And if the dollar remains at current levels, it could add another 2 percentage points to S&P earnings over 1998's, says Kerschner. If the dollar goes lower, earnings get a bigger boost.

BLACK HOLE? That's a lot of ifs, and even if they all work out, there are always some problems that could take the markets by surprise. Economic woes in Brazil and Russia have the potential to roil markets again, and the Year 2000 computer issue will come into ever-sharper focus as the countdown to the millennium goes from months to days.

True, Y2K expenditures are costing companies billions. But it's not a black hole, as most investors believe, says Thomas Galvin, investment strategist at Donaldson, Lufkin & Jenrette Inc. "About 70% of firms have replaced systems rather than fix them," he says. "The key to increasing profit margins is better management of your supply chain, and if you've upgraded for Y2K, you've done that as well." Significant technology spending, he adds, usually leads to a productivity-led expansion in profit margins. Galvin forecasts a heady 13% gain in S&P profits.

Most investors are far less optimistic than Galvin about next year's earnings. Wall Street strategists polled by BUSINESS WEEK are, on average, forecasting a tepid 3.4% gain in 1999 for the companies in the S&P 500. Economists take an even more jaundiced view: They predict only a microscopic gain of 0.1%. Looking at the S&P "bottoms up" forecasts--by analysts for companies that are in the index--the numbers are high, up 17%. But that's typical for analyst forecasts at the start of the year. These numbers are inevitably shaved as the year goes on.

Nor are the portfolio managers at large institutions that control billions of dollars in equity funds optimistic about earnings. Galvin says one poll shows a majority of the firm's institutional investor clients expect earnings in the -5% to 5% range. "Seventy percent of my clients think we're in a bear market," says veteran investment strategist Elaine M. Garzarelli of Garzarelli Capital Inc. "That's because they're looking at what earnings are now, and that's not important." She says the market has long since discounted the current earnings weakness and is rising in expectations of the profit recovery she thinks will be evident by the second half of 1999. Garzarelli, who turned bullish right before the market took off in October, is aiming for 1400 on the S&P in the next 12 to 18 months from today's 1163. That's equivalent to about 11,000 on the Dow.

Dow 11,000? After the last few weeks, that sure seems like a stretch. And even if it gets there, the trip will be jarring. PaineWebber's Kerschner says the Dow's average daily price change in 1998 is 0.92% up or down, 33% greater than the average for the past three decades and the highest level of volatility since 1987. What that means, he says, is that a 60-point move on any day and a 150-point move once a week is just business as usual.

Even if you can stand the volatility and you agree that profits will improve, large-cap stocks are not undervalued. Investors with a little more appetite for risk will find better bargains among the midcap and small-cap stocks. These companies, which historically traded at price-earnings ratios above those of the large-cap stocks, are currently boasting p-e's that are below the S&P's. That's because their stock prices have lagged badly. Through Dec. 15, the S&P 500 climbed 19.8%, but the S&P MidCap 400 index managed a gain of just 4.2% and the S&P SmallCap 600 dropped 10.8%. The 30-stock Dow, which doesn't have dynamic growth stocks such as Microsoft, Intel, and Cisco Systems, is up just 11.6%.

OVERSHADOWED. Midcap stocks, often overshadowed by both larger and smaller companies, offer some of the best earnings growth around. "Midcaps give you much of the same growth as small caps, but more liquidity," says Claudia E. Mott, director of small-cap research at Prudential Securities Inc. Indeed, the midcaps' 10.2% earnings gain in 1998 has been largely ignored, and the bottoms-up profit forecast for 1999 is nearly 19%. Expectations for small caps are even higher, yet the stocks continue to lag.

What might finally push small-cap companies ahead of the large caps in 1999 is the Federal Reserve's monetary policy. When the Fed took short rates down by nearly three percentage points in 1991, small caps zoomed 45%. And smaller companies continued to beat large companies for two more years.

There's no telling how far the Fed will go in the new year, but the direction is down. And there's no question that lower rates are bullish for stocks. Add in a little better than expected earnings, and the market has fuel to keep climbing.