Earnings: Where's the Growth?

With corporate profit gains slowing, S&P doesn't see much upside potential from current levels for stocks this year

The second quarter 2007 earnings season got off to a rough start last week, with Home Depot (HD), D.R. Horton (DHI), Ryland Group (RYL), and Sears Holdings (SHLD) among the companies revealing that housing-related weakness appears to be having a continuing damaging effect on consumer spending and the consumer discretionary sector.

Meanwhile, Standard & Poor's Ratings Services (an entity that operates independently of S&P Equity Research) downgraded some 500 subprime classes of debt totaling $6.4 billion in rated securities, dampening any hope of a swift end to housing and mortgage-related weakness.

The discussion on the fundamental profit environment during S&P's Investment Policy Committee meetings continues to revolve around an expected lack of real earnings progress in 2007. S&P analysts estimate the S&P 500 index will post only 5% profit growth in the second quarter, a continued deceleration from the 8% increase posted in the first quarter of 2007.

It is not only the relatively low prospects for earnings growth that are of concern, but rather the components of growth itself. S&P estimates that favorable foreign currency translation will contribute about 2% or 3% to quarterly earnings growth this year, with stock buybacks adding another 1% to 2%. Meanwhile, simple inflation is contributing 2% to 3%.

When overall earnings growth is 14%, as it was for all of 2006, favorable foreign currency translation and stock buybacks are merely nice kickers to the earnings story. But now, with earnings growth expected to be only 7% in 2007, these former boosters are accounting for much of the total.

The IPC is also concerned about the back-end loaded expectations for the year. While the "500" saw 8% earnings growth in the first quarter, as mentioned, S&P analysts foresee 5% expansion in the second quarter and 2% in the third quarter. But the current estimate for earnings growth in the fourth quarter stands at 13%. While hope springs eternal, fourth-quarter growth estimates may need to be ratcheted down. After all, the "500" posted only 9% earnings growth in the fourth quarter of 2006, after three strong quarters earlier that year. Absent an interest rate cut or significantly lower oil prices, we believe the back-loaded picture and such reliance on a single quarter raises doubts as to whether 2007 full year earnings growth expectations can be met.

S&P's Investment Policy Committee (IPC) has a year-end target of 1,510 for the S&P 500, with the index already slightly above that level. What gives? Quite simply, the IPC believes the market has gotten ahead of itself and will remain range-bound for the remainder of the year.

S&P continues to recommend a portfolio diversified across different assets and sectors. Our Model ETF Portfolio, which tracks our asset allocation advice, is available on our website, www.outlook.standardandpoors.com.

We continue to advise a 65% weighting in stocks, including 40% in U.S. equities - because stocks continue to look more attractive than bonds or cash at this time. Based on S&P analysts' target prices, the S&P 500 should hit 1677 by June of 2008.

Our recommended sectors are consumer staples, which is tracked by the Select Sector SPDR-Consumer Staples exchange-traded fund (XLY), and health care, which is tracked by the SPDR-Health Care exchange-traded fund (XLV).

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