The Great Earnings Illusion

This earnings season has been full of surprises. In the first three weeks alone, 50 companies in the Standard & Poor's 500-stock index—roughly 70% of those that have reported so far—have exceeded analyst expectations, while a mere 17 have disappointed.

Are the strong profits a sign the economy is on the mend? Investors think so. Since July 7, the S&P 500 has jumped 8%.

But the recent spate of good news may not augur the end of the hard times. While some corporate profits are based on economic growth, others are the result of one-time gains such as asset sales and cost cuts. "Companies had been preparing to survive the second coming of the Great Depression," says Wells Capital Management's chief investment strategist, James W. Paulsen. And the stock market rally could prove fleeting as investors sort out whose earnings are real and whose are illusory.

Some companies are seeing improvements in their core businesses. Caterpillar (CAT), whose profits beat analyst estimates by 172% in the latest quarter, raised its yearend forecast for earnings. Management at the industrial equipment maker figures government stimulus should spur infrastructure spending in the U.S. Caterpillar also is banking on its mining and energy customers having the confidence to buy equipment now that commodity prices are on the rise.

There's even hope in the financial sector. JPMorgan Chase (JPM), which reported profits of $2.7 billion, is getting a lift from the acquisitions of Bear Stearns and Washington Mutual—and capitalizing on the weakness of others. The bank "is taking a tremendous amount of market share," says T. Rowe Price's (TROW) portfolio manager, Jeff Rottinghaus.

Still, many look like one-hit wonders; their outlook for revenues is weak, and large portions of their profits are the result of short-term boosts. On July 21, Starbucks (SBUX) reported earnings that beat estimates by 26%. But much of the gains came from the expense side of the earnings equation. The coffee chain trimmed spending by $175 million in the last quarter and plans to reduce costs by an additional $180 million this year. Earnings at Dow Chemical (DOW) spiked for similar reasons. "Many places are shedding jobs at a rapid rate," says MFS Investment Management's chief investment strategist, James T. Swanson. But "you can't cut your way to prosperity. You need something to fuel the recovery."

Edited Estimates

Asset sales are providing another support to earnings. Citigroup (C) reported profits of 49¢ a share, while analysts estimated a 37¢-per-share loss. But if not for a one-time gain from selling Smith Barney, the bank would have experienced a net loss of about 70¢, according to independent research firm CreditSights.

Meanwhile, the earnings surprises may be misleading. Consider Marriott International (MAR). The hotel chain topped analyst expectations by 10% in the second quarter. Those estimates, though, have been lowered several times in recent months, making them easier to beat in the end.

It's much the same across the market. In January analysts predicted companies in the S&P 500 would make $134 billion. The forecast had dropped to $98 billion six months later. Says Swanson: "Expectations were so low."

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