Confidence Expected to Return

Background conditions are improving

By Arnie Kaufman

With the many unfavorable surprises of the past two years continuing to weigh on investor psychology, recent favorable economic reports have been unable to produce sustained demand for stocks. It looks like it will take fairly clear signs of improvement in corporate profits to spur investors to action.

The economy may or may not have been in a recession in the past year, but corporate profits certainly were. We estimate that operating earnings on the S&P 500 fell 31% in 2001, one of the poorest showings on record.

The plunge in earnings on only a modest and brief dip in GDP reflects to a large degree the huge decline in profits of information technology companies that are heavily weighted in the S&P 500. According to S&P research director Ken Shea, capital poured into the tech sector in the late 1990s, fostering rapid earnings growth, with some of the gains coming from liberal accounting practices. But the capital inflow also created a huge amount of excess productive capacity that, as sales forecasts were revised downward, led to a collapse in spending on new equipment.

Earnings in general should be flat to up slightly on a year-to-year basis for the first quarter. More favorable comparisons are likely over the balance of the year. Despite talk that the economic rebound will be slow and erratic, forecasts of GDP growth for 2002 are quietly being adjusted upward. Aided by lower taxes, the near-term outlook for consumer spending remains good, even though debt levels are high and the unemployment rate should continue to rise through about midyear. Housing remains strong, thanks to low mortgage rates and good weather. Government spending is climbing. And even orders for high-tech products have risen for three months in a row.

We suspect that confidence will gradually improve, and we advise maintaining a bullish investment policy. Small and midcap issues are expected to continue to outperform their large-cap counterparts.

Kaufman is editor of Standard & Poor's weekly investing newsletter, The Outlook

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