Slower Earnings Growth Ahead?

After setting a torrid pace over the past two years, S&P expects profit increases to settle down somewhat in 2005

By Sam Stovall

As the week of Jan. 10 week kicks off a new quarterly earnings reporting season, it's worth noting that most investors have become spoiled by the strength in S&P 500 earnings over the past few years, with results consistently coming in better than expected.

What's more, the S&P 500 has posted double-digit, year-over-year increases in operating earnings during each of the past 10 quarters (7 saw advances of more than 20%), with the 2004 fourth quarter projected by S&P analysts to mark number 11, with a gain of 18%.

For the final quarter of 2004, S&P expects all sectors in the S&P Composite 1500 to post year-over-year earnings increases, led by 68% advances for Energy and Materials, upper-20% increases for Health Care and Tech, and a 19% rebound for Telecom Services. Single-digit gains are expected for Consumer Staples, Utilities, and Financials.

SMALL-CAPS LEAD.

  However, 2005 is a different story. S&P forecasts that earnings growth will slow markedly this year, with the S&P 500 projected to report sub-20% year-over-year increases in each of the four quarters. Of course, it's not like earnings are expected to decline.

As shown in the table below, operating earnings per share are seen rising 10% for the S&P 500, 15% for the S&P MidCap 400, and 20% for the S&P SmallCap 600. And the second half is projected to show a slight improvement over the first.

Which sectors will lead the market? The best performances are expected to be seen from Materials and Technology, while Energy and Telecom Services should post the smallest increases. The five S&P 1500 industries with the best 2005 earnings projections are Commodity Chemicals (+258%), Diversified Metals & Mining (+134%), Oil & Gas Drilling (+81%), Advertising (+77%), and Wireless Telecommunication Services (+75%).

On the downside, the five industries with the worst full-year earnings expectations include Insurance Brokers (-8%), Automobile Manufacturers (-10%), Steel (-12%), Oil & Gas Refining, Marketing & Transportation (-16%), and Forest Products (-39%).

  OPERATING EPS % CHANGES, YEAR-OVER-YEAR
S&P 1500 Sector 2004 Q1A 2004 Q2A 2004 Q3A 2004 Q4E Year 2005 Q1E 2005 Q2E 2005 Q3E 2005 Q4E Year
Consumer Discretionary 54 32 24 10 27 6 9 12 18 11
Consumer Staples 3 13 12 3 8 5 3 3 11 5
Energy 4 68 57 68 46 22 2 (6) (9) 1
Financials 35 16 2 6 14 (1) 3 16 14 8
Health Care 10 38 14 27 22 11 9 10 13 11
Industrials 45 15 18 16 22 14 30 16 11 18
Information Technology 84 128 44 28 59 23 22 24 19 22
Materials 119 90 109 68 94 33 17 15 35 24
Telecommunication Services (15) (9) 5 19 (1) 12 5 (4) 3 3
Utilities (5) 30 (15) 4 (1) 18 4 23 8 14
S&P Composite 1500 28 32 17 18 23 10 9 12 12 11
S&P 500 27 31 17 18 23 9 9 11 11 10
S&P 400 37 36 13 16 24 14 11 17 18 15
S&P 600 35 38 35 39 37 20 17 22 21 20

BEATING THE BUBBLE ERA.

  During 2005, the S&P 500 is projected to post full-year per-share earnings under generally accepted accounting principles (GAAP) in excess of $60 and operating earnings above $70 -- both of which are records, even including the bubble years of not-so-long ago.

And yet, in our view, equity valuations are not out of line. In fact, the S&P 500's GAAP p-e of 20.7 is a shade below its average of 21.5, dating back to 1984. But we note that the S&P 500 would have to decline 25% in order for its current p-e to equal the average p-e of 15.5 since 1935.

Industry Momentum List Update

For regular readers of the Sector Watch column, here's this week's list of the industries in the S&P 1500 with Relative Strength Rankings of "5" (price performances in the past 12 months that were among the top 10% of the industries in the S&P 1500), their proxies (the highest STARS-ranked companies in the subindustry index -- tie goes to the largest market value) as of Jan. 7, 2005.

Industry Company Ticker STARS Recent Price
Agricultural Products Archer-Daniels-Midland ADM 3 $22
Commodity Chemicals Lyondell Chemical LYO 3 $28
Consumer Electronics Harman International HAR 3 $117
Fertilizers & Agricultural Chemicals Scotts Co. SMG 4 $69
Hotels, Resorts & Cruise Lines Carnival CCL 4 $58
Internet Retail eBay EBAY 3 $107
Internet Software & Services Yahoo! YHOO 4 $36
Managed Health Care PacifiCare PHS 5 $56
Multi-Sector Holdings Leucadia Natl. LUK NR $43
Oil & Gas Refg., Mktg. & Trans. Valero Energy VLO 4 $43
Steel Nucor NUE 3 $49
Wireless Telecom Svcs. Nextel Partners NXTP 4 $20

Required Disclosures

5-STARS (Strong Buy): Total return is expected to outperform the total return of the S&P 500 Index by a wide margin, with shares rising in price on an absolute basis.

4-STARS (Buy): Total return is expected to outperform the total return of the S&P 500 Index, with shares rising in price on an absolute basis.

3-STARS (Hold): Total return is expected to closely approximate the total return of the S&P 500 Index, with shares generally rising in price on an absolute basis.

2-STARS (Sell): Total return is expected to underperform the total return of the S&P 500 Index and share price is not anticipated to show a gain.

1-STARS (Strong Sell): Total return is expected to underperform the total return of the S&P 500 Index by a wide margin, with shares falling in price on an absolute basis.

As of December 31, 2004, SPIAS and their U.S. research analysts have recommended 26.5% of issuers with buy recommendations, 61.3% with hold recommendations and 12.2% with sell recommendations.

All of the views expressed in this research report accurately reflect the research analysts' personal views regarding any and all of the subject securities or issuers. No part of the analysts' compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this research report.

Additional information is available upon request to Standard & Poor's, 55 Water Street, New York, NY 10041.

Other Disclosures

This research report was prepared by Standard & Poor's Investment Advisory Services LLC ("SPIAS"), and may have been provided to you either by: (i) Standard & Poor's under a license agreement with The McGraw-Hill Companies, Inc., which holds the copyright to this report; or (ii) a Standard & Poor's client who is granted a sub-license by Standard & Poor's. This equity research report and recommendations are performed separately from any other analytic activity of Standard & Poor's. Standard & Poor's equity research analysts have no access to non-public information received by other units of Standard & Poor's. Standard & Poor's does not trade in its own account. SPIAS is affiliated with various entities, which may perform services for companies covered by the recommendations in this report. Each such affiliate is operationally independent from SPIAS.

Disclaimers

This material is based upon information that we consider to be reliable, but neither SPIAS nor its affiliates warrant its completeness or accuracy, and it should not be relied upon as such. Assumptions, opinions and estimates constitute our judgment as of the date of this material and are subject to change without notice. Past performance is not indicative of future results.

This material is not intended as an offer or solicitation for the purchase or sale so any security or other financial instrument. Securities, financial instruments or strategies mentioned herein may not be suitable for all investors. This material does not take into account your particular investment objectives, financial situations or needs and is not intended as a recommendation of particular securities, financial instruments or strategies to you. Before acting on any recommendation in this material, you should consider whether it is suitable for your particular circumstances and, if necessary, seek professional advice.

Stovall is chief investment strategist for Standard & Poor's

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