That Sound on Wall Street: The Silence of the Optimists
That noise you don’t hear is the sound of corporate America warning about disappointing first-quarter profits.
Typically at this time each quarter, Wall Street is hit by a barrage of earnings “pre-announcements,” whereby companies swallow hard and admit that their profits in the just-ended quarter won’t meet expectations.
But this time around, “there’s been a definite falloff in the number of (negative) pre-announcements,” says Ben Zacks, head of earnings-tracker Zacks Investment Research in Chicago.
More prominent, instead, have been the positive earnings pre-announcements: General Electric, brokerage Charles Schwab & Co. and truck engine maker Cummins Engine, for example, all issued upbeat first-quarter earnings forecasts last week.
And computer workstation giant Sun Microsystems, which last Monday warned that first-quarter sales would be below expectations, surprised Wall Street on Wednesday by reporting that earnings came in above expectations despite the sales shortfall.
If the good news so far foreshadows the general tone of first-quarter earnings, the end result could be much-needed support for the stumbling stock market.
Stung by rising interest rates, investors have been struggling to find a reason to hold on to stocks, let alone to buy more. Wall Street’s optimists have been arguing vociferously that the bull market isn’t dying, but is merely in transition--from being driven by low interest rates to being driven by rising corporate earnings.
If that’s true, the best thing for stocks would be for the bond market to remain relatively calm this month while strong quarterly profit reports grab the business headlines day after day.
In theory, earnings ought to be pretty good. The economy surprised nearly everyone with the strength of its advance in the first quarter, even in the face of the Northridge earthquake and lousy weather in much of the country.
Booming sales of homes, cars, computers, machinery and other big-ticket items should translate into higher profits not only for the companies that produce them but for the myriad supplier businesses.
Yet Wall Street analysts, apparently choosing to play it cautious on the economy despite evidence to the contrary, continually chipped away at their earnings estimates as the quarter progressed, Zacks says.
That has been the pattern of the last five quarters, he says: “The analysts lower their estimates going into the reporting period. Then the numbers come in slightly better than expectations, and (the analysts) start raising their numbers again” for the next quarter--at least for a month or so.
Tallying up analysts’ estimates for the blue-chip companies in the Standard & Poor’s 500 index, Zacks says the average S&P; company is expected to report first-quarter operating earnings (i.e., results before any one-time gains or losses) up 11.7% from a year earlier.
At the end of January, the analysts had expected S&P; operating earnings to rise 15.7% for the quarter, Zacks says.
“Expectations are fairly moderate” now, agrees Melissa Brown, who tracks corporate earnings trends for Prudential Securities in New York. “So it’s seems unlikely that we’ll have a lot of negative surprises” as the numbers are reported, she says.
And if analysts have again been too cautious, the stock market could benefit as higher-than-expected profits force investors to reconsider stocks’ prices relative to potential earnings power in an expanding economy.
Abby Cohen, investment strategist at Goldman, Sachs & Co. in New York, is one of the earnings optimists. She expects S&P; 500 operating earnings, which jumped 16% last year, to rise 12% this year and another 10% in 1995 as the economy continues to grow.
While Wall Street’s bears believe the stock market will be strangled by rising interest rates, Cohen notes that rates don’t rise nonstop, even in a healthy economy. Once the bond market settles down from the selling frenzy of recent weeks, she expects investors to focus again on stocks’ individual fundamentals.
And on that count, she says, there are still plenty of reasons to feel good about the market.
“It would be extremely unusual to see the market peak when we have a couple years of earnings growth still ahead,” she says.
Unless, of course, stocks have become overvalued. That’s the bear case: Even though earnings are going up, the 42-month-old bull market has already factored higher earnings--even into 1995--into stocks’ prices, the bears say.
Therefore, there is nothing for Wall Street to look forward to except the next recession and the next cycle of lower earnings. Add rising interest rates to the equation, and you get falling stock prices even as earnings surge in 1994, the bears contend.
In Wall Street jargon, the term for that is multiple compression : Stocks’ price-to-earnings multiples, or P-Es, slowly shrink because stock prices (the numerator in the equation) go down while earnings (the denominator) go up, at least in the near term.
Or to put it another way, investors lower their valuation of stocks, or what they consider a fair price to pay relative to longer-term earnings expectations and to the returns on competing investments, such as bonds and money market accounts.
“People are worrying that what we get in earnings (growth) will be lost in valuation as interest rates go up,” says Prudential’s Brown.
But Cohen and other bulls didn’t consider stocks to be overvalued before the recent dive in prices. Thus, they argue, today’s lower prices are an invitation to buy, not a warning of worse to come.
Based on Goldman Sachs’ earnings estimates, the average S&P; 500 stock sells for 14 times 1994 operating earnings. Historically, the market’s P-E has averaged 16.4 in periods when inflation ran at 3.5% or less annually, Cohen says.
So if you believe, as she does, that inflation (and, by proxy, interest rates) will remain subdued, the stock market could advance 17% from current levels and still not exceed historic “fair” valuation levels.
Of course, it’s easy to talk about fair valuation for the market as a whole. But most portfolio managers aren’t buying the market--they’re buying individual stocks.
That’s why so much may ride on the first-quarter earnings reports that will swamp Wall Street starting this week: If the individual numbers aren’t good enough to make shareholders want to hold on--after the turmoil of the past few weeks--the market’s slide may resume, and what had been a long-overdue “correction” in prices could rapidly become something far worse.
The lack of downbeat pre-announcements so far is certainly encouraging. But earnings-tracker Zacks adds a caveat: There’s a chance that many companies with bad news to release didn’t do so early because they feared they would accelerate the recent stock selloff.
Overall, Zacks looks for strong quarterly earnings gains from auto, semiconductor, bank and industrial companies, while results from energy, airline, drug and food companies are expected to be weak.
Briefly: At last, a survey in which Los Angeles doesn’t finish last.
Money magazine says major L.A.-area stocks racked up the biggest gains in the first quarter of stocks in 24 metropolitan areas tracked by the magazine.
Each of Money’s regional stock indexes is made up of 12 companies viewed as representative of the local economy.
The L.A. index jumped 7.3% in the quarter, helped by big gains in shares of Carter Hawley Hale, Dole Food and National Medical Enterprises.
The No. 2 region in the quarter was Cincinnati, where stocks were up 3%. Next were San Francisco, up 1.7%, and Boston, up 1.2%.
At the bottom: New York City, down 12.9%, San Diego, down 9.8%, and Pittsburgh, down 9.4%.
And When the Bear Finally Visits. . .
For many stock investors, the issue isn’t necessarily how much they’d lose in a bear market, but how long the pain would last. The following shows the duration of major declines in the Standard & Poor’s 500 stock index since 1953, and how long it took afterward for the market to recover 75% and 100% of each decline.
S&P; 500 Duration No. of months to recover: Period decline (months) 75% of loss 100% of loss 1953 -15% 9 4 6 1956-57 -16 6 3 5 1957 -20 3 11 12 1961-62 -29 6 10 14 1966 -22 9 5 6 1968-70 -37 18 9 22 1973-74 -48 21 20 64 1975 -15 2 2 4 1977-78 -18 14 1 6 1978 -17 2 7 10 1980 -22 2 3 4 1981-82 -22 13 2 3 1987 -34 2 18 23 1990 -20 3 5 5 Average -28 8 7 13
Source: David L. Babson Co.
