Wanted: The Right Kind of Profits

Higher third-quarter earnings may not be enough to reinvigorate the rally. Investors yearn for top-line growth, not just cost-cutting

By Eric Wahlgren

If third-quarter results from a trio of Wall Street banks are any guide, the coming earnings season looks promising. Morgan Stanley (MWD ), Goldman Sachs (GS ), and Lehman Brothers (LEH ) all managed to post higher profits that topped analyst expectations, as the firms emerge from a long investment-banking slump.

Indeed, as the unofficial Oct. 7 kick-off of the quarterly profit reporting season nears, Wall Street analysts have been doing something downright unusual: Raising earnings estimates for companies. During the bear market, most equity research analysts couldn't cut profit targets fast enough. But that trend seems to be reversing.

The ratio of negative to positive "preannouncements," as guidance is called, is running at 1.6, well below the historic norm of 2.5 to 2.6. "If I had to bet, I would say that the consensus numbers would be exceeded," says Richard Moroney, editor of the newsletter Dow Theory Forecasts in Hammond, Ind. "It looks pretty positive. What we always want to see, however, is how the stock prices react."


  Unfortunately, the answer may well be: not much. Stocks have already moved up a bunch since March, with the benchmark Standard & Poor's 500-stock index adding some 29%, as economic reports have given investors hope that the U.S. economy is waking up from its long nap. Today, S&P 500 stocks are trading at an average of nearly 20.3 times their 12-month forward earnings. Historically, the price-earnings ratio for the index has hovered closer to 17.

"We're pretty close to the max in terms of p-e ratios," says Barry Hyman, an independent market strategist based in New York. "We're probably not going to see much multiple expansion until it is proven that this is a lasting economic recovery."

In recent days, stock prices have backtracked as Wall Street sorted through mixed messages about economic prospects. For instance, one report out in September showed the U.S. housing market still on a tear, with new homes sales jumping 3.4% in August. Then another report revealed that orders for factory goods had fallen unexpectedly in the same month.


  Economists see gross domestic product growth humming along at a not-too-shabby 4% to 5% for the rest of the year. But the rebound is still being led mainly by consumer spending and government stimulus, strategists say. Consumers could decide to throw in the towel if the job market doesn't get out of its rut soon. And while the tax relief has kicked in, the effects of monetary stimulus haven't fully materialized.

Also worrying, business spending appears to have perked up only slightly. Says Mark Sellers, editor of Morningstar's StockInvestor newsletter: "If it was business spending we were relying on, we would still be in a recession and maybe even a depression."

What's troubling to market pros is that top-line growth doesn't seem to be the reason for the expected increase in third-quarter earnings. First Call sees third-quarter revenue growth among S&P 500 companies matching last quarter's number -- a rather middling 7.5%. That means earnings gains will largely be attributed to the same corporate belt-tightening of the last few quarters -- the trend that has resulted in greater productivity, but not necessarily greater sales.


  While bringing costs in line usually expands profit margins, the increased earnings that result aren't always the kind that send stocks climbing. "Going forward, you can't cost-cut forever," Moroney says. "It's going to be crucial that companies show some improvement on the top line."

Still, this earnings season seems certain to be the best in several quarters. Analysts have pegged profit gains for companies in the S&P 500 at 15.1%, according to earnings tracking service First Call. That's up from a 14.5% average estimate at the beginning of the month. Growth may be closer to 19% by the time reporting ends, First Call says, making it the best quarter since the second quarter of 2000, when profits jumped 21%.

And what could send stocks higher are the hints CEOs give in their profit reports about business prospects for next year. By the time an earnings season rolls around, stock prices have already factored in the expected results, and investors have moved on to anticipating future quarterly performance. For now, First Call's surveys predict fourth-quarter earnings growing by 21.7%, while profits for all of 2004 are seen rising 13% vs., 16.8% for 2003. (Year-over-year comparisons will be tougher next year because of the earnings recovery this year.)

In the short term, though, Hyman doesn't expect stock prices to push much higher unless the moves can be justified by signs that increased demand is what's driving revenue and profit gains. "It's no wonder that we are having a little trouble here at the 1,030 level in the S&P 500," Hyman says. (The index was trading was trading in the 1,012 range on Sept. 24.) The bull market may not have ended, but it could be at somewhat of a standstill -- despite the approach of a solid earnings season.

Wahlgren covers financial markets for BusinessWeek Online in New York

Edited by Beth Belton

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