Earnings Reports Force Investors To Look Ahead

Investors searching for an excuse to sell red-hot stocks may find it in second-quarter corporate earnings reports.

At least, that appeared to be the message on Tuesday as Wall Street trounced shares of major paper and lumber firms. Despite seemingly strong earnings reports from International Paper and Champion International, those stocks were hammered, in turn undercutting the broad market.

International Paper, for example, plunged $4.125 to $86.625 even though it reported record quarterly earnings of $2.49 a share, 5 cents more than analysts’ consensus estimate.

The bloodletting in the paper issues was somewhat offset by a well-received report from technology bellwether Motorola, which climbed from $68.375 to $70.50 in after-hours trading after it announced earnings of 79 cents a share, a 25% gain from 1994 and 6 cents above expectations.

Still, the paper stocks’ sudden slump is an indication of Wall Street’s skittishness, with the Dow Jones industrial average up 22% this year while the economy has weakened. Some investors may just feel it’s prudent to take some money off the table. Others may have expectations for second-quarter earnings that simply can’t be met.

Indeed, given the economy’s sharp slowdown in the quarter, somebody’s bottom line is bound to be hurt. “I think we are going to see a disappointing quarter, and I think it’s going to be pretty broad-based,” warns Melissa Brown, who tracks earnings for Prudential Securities.

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Yet for many investors the big issue won’t be second-quarter results, but what will follow them in the second half of 1995 and in ’96.

In retrospect, it’s clear now that a major reason stocks didn’t collapse last year--even as interest rates surged--was that investors could see robust earnings growth continuing into 1995. Double-digit first-quarter gains demonstrated that the bulls were on target. And even if Prudential’s Brown is right about disappointments in the second quarter, the International Paper and Motorola reports show there still will be much strength.

But faith is ebbing about the rest of the year and 1996. Since May, Wall Streeters have been cutting full-year ’95 estimates for many firms, figuring economic weakness will pull down results in the second half. “Analysts have turned a lot less optimistic,” says Ben Zacks at earnings-tracker Zacks Investment Research in Chicago.

Brokerage-house investment strategists, for example, on average now expect total operating earnings of the Standard & Poor’s 500 list of blue-chip stocks to rise just 6.5% in 1995 over 1994, after three years of double-digit growth. In 1996, they expect the S&P; companies to earn a mere 4.5% more than in 1995, Zacks says.

The strategists’ “top-down” ’95 growth forecast is much weaker than the 20%-plus earnings growth many individual analysts still expect for their specific companies and industries. But that wide gulf (6.5% versus 20%) is itself troubling, Zacks says: “Somebody’s got to be wrong.”

If the strategists are right, and earnings growth will dwindle significantly this year and in 1996, what happens to stocks? With the average blue- chip stock now selling for between 15 and 16 times estimated 1995 earnings, many investors may consider that fair valuation--which means stock prices don’t have to go down a lot. But without more substantial upside to earnings, it’s hard for some pros to justify pushing stocks higher soon.

The bulls, however, say the pessimists ignore two strong possibilities. One is that earnings may continue to rise handsomely, which is the view of strategist Abby Cohen at Goldman, Sachs & Co. in New York. Yes, the economy has slowed, she says, but she sees it picking up enough in the second half to boost S&P; earnings 10% this year and at least 8% in ’96. She also thinks U.S. companies’ competitiveness abroad may be underestimated.

The other possibility is that interest rates may continue to decline even as the economy grows modestly. If rates fall, investors may be willing to pay much higher stock prices for the same level of earnings. “If you take the view that stocks can sell for 18 to 20 times earnings [on average], you get a big market move even from here,” says strategist Suresh Bhirud at Bhirud Associates. On Wall Street, stranger things have happened.

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Fading Profits?

After three years of double-digit gains, earnings of major U.S. blue chip companies are expected to be up just 6.5% this year, on average. S&P; 500 companies’ operating-earning gains 1990-94, and investment strategists’ consensus estimates for ’95 and ‘96: 1995*: 6.5% 1996*: 4.5%

* Estimate

Source: Goldman Sachs; Zacks Investment Research