Corporate Profits and the Fed

Earnings continue to be strong, and the Fed may be almost finished tightening. S&P thinks that combination is a plus for stocks

By Joseph Lisanti

Inflation is contained, and corporate earnings are strong. That's usually good for stocks, as recent market action has confirmed. But where do we go from here?

By its nature, the stock market is a forward-looking beast. Although we are just a month beyond the halfway mark in 2005, the focus of attention is already moving to 2006.

On the profit front, we expect companies in the S&P 500 to continue to do well. Our forecast for 2006 operating earnings on the index is 83.40, another record, and 10% above the 75.68 we now see for 2005.

Standard & Poor's has tracked operating earnings on the "500" since 1988. As a result, we have data on annual percentage changes in operating earnings for 16 years, from 1989 through 2004. The average annual gain for that period has been 8%. So even though we are not likely to see the 24% rise in operating earnings that we had in 2004, our projection is for a better-than-average advance next year.

In addition to the good earnings picture, we expect that stocks will get a lift when investors are convinced that the Federal Reserve is almost finished with its rate hikes. When the Fed meets next on August 9, Standard & Poor's economists expect that it will again boost the fed funds rate (what member banks charge each other for overnight loans) by 25 basis points (one quarter of a percentage point).

Unless conditions change dramatically, we also believe that the Fed will stop when the fed funds rate reaches 4%. Even allowing for an unchanged rate at one scheduled Fed meeting, the end of rate tightening appears likely by December. We think any signal by the Fed that rates will not be boosted further is likely to spark a decent rally in stocks.

Our forecast is that the S&P 500 will end this year at 1270, and we project 1335 at yearend 2006.

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

    Before it's here, it's on the Bloomberg Terminal.