Those Dark Clouds over the Street

Earnings haven't been bad, just not as good as earlier quarters. Factor in election anxiety, Iraq, and oil prices, and investors' mood is no mystery

By Amey Stone

The third quarter of 2004 will be remembered as the year corporate earnings came back down to earth. For the prior four quarters, investors had been treated to earnings seasons that were truly stellar. Each quarter profit growth for companies in the Standard & Poor's 500 came in at better than 20%, with far more companies beating Wall Street expectations than is typical -- and by bigger margins.

This time around, profit growth is slower -- about 15% -- mostly due to tougher comparisons with the strong third quarter of 2003. This quarter's results are pretty much in line with what analysts forecast back in July. That's hardly the pits, but this reporting season certainly hasn't felt too good.


  "That's because we've had such positive results for the past four quarters," says John Butters, a research analyst at First Call. As far as the mix of companies that beat analyst's expectations (vs. met or missed), it is running at about the same rate as usual: 60% beat, 20% match, and 20% miss. In the prior four quarters though the "surprise factor"-- for those companies that did beat earnings -- was much more dramatic.

Another reason earnings seem just so-so is because so much of the strength is due to rising prices of energy and other commodities, which makes for soaring earnings in a few sectors, but doesn't reflect broader profit growth, points out Barry Ritholtz, chief market strategist at the Maxim Group. Earnings in the basic-materials sector are up 76% and in the energy sector 49%. But "you back out energy, and you really aren't looking at a very impressive set of earnings," he says.

Technology is the third-strongest sector for earnings growth -- up 37% over the past year so far, according to First Call. Sparking excitement were results from Apple Computer (AAPL ), which reported earnings of 27 cents a share, vs. analysts' estimates for 18 cents, and Texas Instruments (TXN ), which clocked in with 32 cents when analysts were expecting 27 cents.


  Even among tech stocks, there is a sobering consideration: Some of the strongest results have come from premier dot-com names like Google (GOOG ), eBay (EBAY ), and Yahoo (YHOO ). "They are just hitting it out of the park right now," says Tom Taulli, a principal at investment firm Bridgewater Capital. "But they may be taking business away from traditional companies," he surmises.

As is often the case, probably the biggest reason for the impression of a lackluster earnings season isn't the actual results, but the management commentary that affects how investors view the results. "Everyone seems to be very conservative," says Ritholtz. "You don't hear a whole lot of noise about capital spending and hiring." His fear is that without the extra stimulus of tax cuts or interest-rate cuts, "it seems you're left with a go-slow economy and that is nothing to write home about."

Many professional investors are starting to surmise that in 2005 earnings will rise, "but not enough to lift stock prices," wrote Ed Yardeni, chief investment strategist at Oak Associates in an Oct. 22 report. However, he believes such pessimism is already factored into stock prices, which leaves room for the market to rally if earnings come in as expected.


  The forecast currently for the first half of 2005 is for 9% profit growth. While that would represent a slowdown from current levels, analysts have been raising their estimates. As of Oct. 1, they forecast less than 8% growth in the first half of 2005, according to Butters. That's an encouraging sign, notes Yardeni.

Mark Foster, chief investment officer at Kirr Marbach Partners, in Columbus, Ind., isn't cheering the earnings outlook, but he isn't mourning it either. "The earnings picture has been pretty good, but there are lots of other things for market to focus on," he says, pointing to -- most pressingly -- the election, but also the war in Iraq and oil prices.

Third-quarter earnings would have had to be simply dazzling to add some luster to the market amidst so many reasons for worry. Instead, earnings are turning out to be just ho-hum. For investors, that amounts to one more reason to keep their enthusiasm for stocks in check.

Stone is a senior writer for BusinessWeek Online in New York

Edited by Beth Belton

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