Second-Quarter Preview

As consumer spending likely slows, S&P thinks the profit picture won't be as bright in the second quarter

The game isn't over yet, but let's declare victory for the first quarter and defeat for the second.

Based on the companies in the S&P 500 index that have reported so far, the first quarter looks very good and appears set to post a 13.7% year-over-year operating earnings gain, marking the 16th consecutive quarter of double-digit gains.

In the quarter, all 10 sectors posted increased earnings. Two-thirds of the companies beat Wall Street's consensus estimates, and three-quarters beat their results from a year ago. Energy sector earnings were up 39%, and those for health care companies rose 23%. Even the materials sector, which has been struggling for the past two quarters, managed a 4.5% gain.

Overall, the S&P 500 has put up four straight months of gains, to produce a 5.6% year-to-date total return (through April). So break out the non-alcoholic champagne, and let's celebrate. It's got to be non-alcoholic because we need to keep a close eye on the second quarter, which we think is not going to be as much fun.

Consumer spending, which made the 16 consecutive quarters of gains possible, is slowing down, from 5.5% growth in the first quarter to an estimated 3.2% in the second period. The first quarter started off with income taxes due, much higher winter heating costs in spite of reduced use, and near-record-high gasoline prices. Add flat income numbers, and you've got a recipe for reduced consumer spending, which we think should quickly translate into lower corporate profits for the second quarter.

There are also a couple of new wrinkles for the second quarter. The first is the rising number of companies that have reduced their share count. The $8.4 billion first-quarter profit that ExxonMobil (XOM) recently reported represented a 6.9% increase from a year earlier, but the company's per-share earnings gain was 12%. That's because ExxonMobil reduced its share count by 4.6%. This also affected the oil giant's price-to-earnings ratio because that valuation measure is calculated using earnings per share. We expect more than 100 stocks in the S&P 500 to be in a similar situation in the second quarter.

Another wrinkle is cash. Cash on the balance sheet continues to go up, and now stands at an all-time high for the S&P industrials (the S&P 500, excluding financial services). So at this point, we also need to look at the impact of interest income. At current levels, income from a 5% instrument, reduced by the statutory tax rate, would increase earnings by 3.9%.

Considering the share buyback situation, upcoming headlines may not tell the full story. We think investors need to review a company's income statement to see where the earnings growth is coming from. In our view, companies will be hard pressed to maintain the double-digit growth that investors want to see. Two of the ways they achieve this growth -- share count reductions and interest income -- are legitimate, but they are also quite different from income derived from the company's business operations. We think investors should look for solid earned income growth and be a bit wary of growth from short-term fixes.

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