Earnings: The Big Picture

While growth should continue to slow through the third quarter, Standard & Poor's says market fundamentals remain positive

For 18 consecutive quarters—from the second quarter of 2004 through the third quarter of 2006—corporations have enjoyed double-digit operating earnings growth. And the initial retreat from double-digit gains looks perfectly orderly, with the fourth quarter of 2006 posting an 8.9% gain and the first quarter of 2007 recording a 7.8% increase.

That current trend is expected to continue. We expect second-quarter earnings to gain 5.7% and third-quarter earnings to rise 2.4%—a rate not seen since the first quarter of 2002, more than five years ago. But this declining growth needs to be interpreted in light of the previous four and a half years of record-setting earnings. Profits are still largely positive, there is no discussion of a recession, and interest rates and unemployment remain relatively low. If this is the payback for a lengthy period of record earnings gains, sign me up again.

Favorable Outlook for Long-Term Investors

Earnings growth comes in cycles, as does business investment, economic expansion, and corporate profits. While slower periods usually mean lower prices, consolidation permits those who want to reallocate or move out of the market to do so without a major correction. Speculators may not be happy, but long-term investors should be, especially when they look at the big picture.

The market fundamentals are good. Price-to-earnings ratios are still relatively low. Companies still have excess cash reserves: Excluding the financial-services sector, stocks in the S&P 500 have more than $600 billion, which is 5.9% of market value and 39.6% of long-term debt. And the long-term debt tied to the prime rate has been significantly reduced, which will help insulate companies from any increase in interest rates.

The U.S. dollar has been weak, but S&P 500 companies are global.

While a weak dollar may not be beneficial to all, it is definitely not as potentially devastating as it was 20 years ago. Then, if the U.S. dollar fell, corporate profits sank with it. While earnings and cash flow are declining, in general we think companies are in good shape to weather a mild storm.

There are, however, concerns—namely, rising interest rates. But rates have been low for years; again, the numbers need to be looked at over a longer time period. Increased rates won't directly hurt companies that much in the short run. If rates increased a full percentage point on all the long-term debt for nonfinancial stocks, it would only reduce their annual earnings by 1.1%. Given their cash positions and ratios, that's not a major impact.

Consumer Spending Can't Keep Up

However, there are many concerns about the consumer. Somehow, consumers have found a way to continue spending in spite of every obstacle that has been thrown at them. This time may be different. With higher interest rates, the cost of all adjustable mortgages will increase. Higher gasoline prices mean U.S. consumers collectively pay an additional $400 million a day. Somehow, most people will find a way to pay their mortgages and continue to drive.

The question is: Where will the money come from? Consumers are already dipping into their savings. The extra cash won't come from refinancing their home, and with a mixed Congress and new spending programs, tax breaks are not in the cards. Consumers will have to cut back spending somewhere, and that will hurt some corporate profits.

The current downturn in earnings is expected to reverse in the fourth quarter. Double-digit growth has been forecast to return and remain throughout 2008. While that's a nice forecast, the reality is that markets, the economy, and geopolitics change quickly. There are no guarantees.

In the meantime, long-term investors should not worry so much about when double-digit growth will reappear. Instead, they should take positions in companies with excess cash reserves, strong cash flow, and experienced management with a long-term business plan. This should allow investors to ride out the period of declining earnings growth—as long or as short as that might be—much easier and hopefully much more profitably.

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