The Market's Mixed Signals

As investors rush in, the fog around future corporate profits looks particularly dense

There's ordinary "uncertainty" of the kind that typically looms over investing decisions. And then there's cosmic uncertainty of the kind that leaves normally resolute and clear-minded investors baffled and frozen. It's looking like earnings forecasts, the biggest driver of the U.S. stock market, may be about to enter the realm of cosmic uncertainty. The question is what investors should do about it.

Cosmic uncertainty is usually born in a period of complacency--like, say, now. With the Standard & Poor's (MHP ) 500-stock index near an all-time record, investors are still gung ho. By one measure, they've never been more aggressive: The value of shares bought on margin is at a record. Their reasons to invest are numerous--interest rates are holding steady, mergers and buyouts are raging, companies are buying back stock like mad, and corporate profits have remained strong.

But a growing array of indicators points to major uncertainty over that last item. U.S. economic growth slowed in the first quarter, gas prices are rising, the corporate bond market seems ready to crack, volatile foreign markets could turn softer at any time, and companies could ease their aggressive stock-buyback campaigns--any of which could send earnings per share tumbling. "Many people in my position are scratching their heads," says William Knapp, strategist at New York's MainStay, a fund company handling more than $35 billion. "We're getting very confusing signals. Yet [investors'] are in La-La Land thinking that, magically, inflation will go away and we will return to a higher level of economic growth and corporate profitability without the possibility of a recession or a financial crisis."

Predicting corporate earnings is turning into an extreme sport. At the start of the year, Wall Street pegged first-quarter growth for S&P 500 companies at 9%. Then the subprime mortgage mess and former Federal Reserve Chairman Alan Greenspan's February warning of recession in 2007 sent analysts running to tweak their models. Within a few weeks' time, they had cut their first-quarter growth estimates to an anemic 3.5%.


Now, with 90% of the companies in the S&P 500 having reported their earnings, it's safe to say analysts overreacted. Profit growth in the first quarter nearly hit the original prediction of 9%, with such diverse U.S.-based multinationals as Schering-Plough (SGP ), NCR (NCR ), and Coca-Cola (KO ) beating expectations by a mile. So far, 66% of companies beat estimates, 12% matched, and 22% missed the forecasts, more deviation than the historical averages of 60%, 20%, and 20%, respectively. "Wall Street analysts really missed the mark," says Ashwani Kaul, a senior analyst with Reuters Estimates (RTRSY ). "Nobody expected [growth] to get anywhere near double digits."

But amid all the positive results were confusing downside surprises, too. Consider the sinking fortunes of JDS Uniphase (JDSU ). Analysts were expecting a modest profit as the Milpitas (Calif.) optical-networking outfit continues to right itself after the telecom bust earlier in the decade. But on May 2, JDSU reported a net loss for its fiscal third quarter of 6 cents a share and lowered its estimate for the rest of 2007, blindsiding everyone.

Analysts' earnings forecast miss the mark all the time, of course. But now the profit visibility is especially limited, say investment strategists. The biggest wild card is the U.S. economy, which posted a lethargic 1.3% growth rate in the first quarter, its lowest in four years. On the corporate side, today's unusually low rate of debt defaults has many credit analysts predicting a bond market selloff, which would jack up borrowing costs for many companies. Says Mariarosa Verde, a managing director for Fitch Ratings Inc.: "The best times are behind us." The last time the credit cycle turned, in 2002, interest rates on junk bonds soared, raising borrowing costs for the most vulnerable companies and eating into profits.

It's also getting more difficult to nail down revenue predictions for companies' overseas operations--a growing problem because most of the momentum for S&P 500 earnings growth is coming from U.S.-based multinationals. For the first time, General Electric Co. (GE ) reported that more than 50% of its revenues in the first quarter came from outside the U.S. Indeed, Howard Silverblatt, senior index analyst at S&P, which like BusinessWeek is a unit of The McGraw-Hill Companies (MHP ), notes that many S&P 500 companies get more than 45% of their sales overseas. "Something contributing even 10% of your earnings is major," he notes. Factoring in the currency fluctuations is hard enough without even worrying about a long-overdue pullback in volatile emerging markets.

And then there are stock buybacks, many of which are being fueled by the booming corporate bond market. The fact that companies are taking on debt not to expand but to retire shares worries Fitch Ratings' Verde. Henry McVey, chief investment strategist at Morgan Stanley, says: "It's the tail wagging the dog." Buybacks boost earnings per share by reducing the share count. So if weakening in the corporate bond market causes companies to reel in their buybacks, it would only magnify the hit to earnings.

So how should investors play things? Hugh Moore of Guerite Advisors, a money manager in Greenville, S.C., offers time-worn advice for periods of cosmic uncertainty: sell riskier holdings to lock in recent gains and stick with bigger, dividend-paying companies in less economically sensitive sectors. That's where you want to be until the profit picture gets clearer. Which it will at some point.

By Mara Der Hovanesian, with Roben Farzad

— With assistance by Roben Farzad

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