Investors Get Message: Company Profits Slowing
Corporate earnings worries hit Wall Street again Monday, triggering new warnings that unrealistic profit expectations have set the stock market up for a sharper fall.
The Dow Jones industrials slid 126.16 points, or 1.4%, to a six-week low of 8,695.60 amid a steep market-wide decline.
Despite more than a year’s worth of turmoil in Asia, severe economic disruptions this year in Russia and Latin America and the aging U.S. economic expansion, many analysts have persisted in calling for continued double-digit profit growth for American companies.
Such projections, coupled with low interest rates and a feeling that baby boomers had few other places to put their retirement savings, have been used to justify record-high stock valuations--and blue-chip stocks’ fast recovery from the August-September plunge.
But with such well-respected companies as Coca-Cola Co., J.P. Morgan and Mattel Inc. in recent days warning that analysts’ earnings estimates are too high, it is getting harder for investors to continue denying that profits are slowing, experts say.
The 3.1% earnings decline in the third quarter for the Standard & Poor’s 500 companies--America’s biggest and best-known firms--was the first year-over-year drop for that elite group since 1991.
Now full-year S&P; 500 profits are on track to rise just 2.5% over 1997 levels, according to First Call Corp., a Boston consulting firm that tracks earnings estimates by Wall Street analysts. That would be the slowest growth rate since, again, 1991.
And all the bad news isn’t yet out: Charles L. Hill, First Call’s director of research, said that based on the trend so far, the number of negative earnings “preannouncements” by major companies in this quarter--334 to date--will almost certainly shatter the record 526 last quarter.
Yet the U.S. economy overall still appears strong by many measures. Few economists expect a recession in 1999, and despite recent layoff announcements, most analysts expect the job market to stay strong next year.
Said Stephen S. Roach, chief economist at Morgan Stanley Dean Witter: “The only thing that’s pessimistic about my outlook [for 1999] is how it will play relative to expectations” of investors.
Roach is projecting a fairly robust 2.6% rise in U.S. gross domestic product next year, but he expects corporate after-tax profits to fall about 5% from this year’s level--well below consensus estimates.
Wall Street’s intense interest in quarterly earnings has spawned a thriving industry devoted to predicting the numbers and even handicapping the predictors.
Stocks can react so sharply to earnings reports that many big companies feel compelled to give advance notice when their profits are likely to stray from the consensus estimates.
These preannouncements, duly recorded by firms such as First Call, can sometimes be major market-moving news.
Last Friday, for instance, when Coca-Cola said its fourth-quarter earnings would fall well below analysts’ average estimate because of slumping overseas economies, the soft drink giant’s stock fell 5%.
Even more dramatically, El Segundo-based Mattel’s stock plunged 27% Monday--the worst one-day drop in 16 years--after it simultaneously announced that it would buy the educational software maker Learning Co. for $3.8 billion and that its fourth-quarter and full-year profit would fall far short of expectations.
Despite the growing list of corporate earnings warnings, Hill said analysts’ consensus profit-growth estimate for S&P; 500 companies for the next five years remains an average of 12% per year--nearly double the 7% year-in and year-out average established over the last 40 or 50 years.
For 1999 alone, analysts are betting S&P; 500 profits will rise about 19%, according to First Call.
Hill and others say that the longer analysts and investors persist in unrealistic expectations, the harder the market will fall when it finally wakes up.
For many companies, weak earnings stem from an unhappy confluence of events that is depressing sales and slashing profit margins.
The Asian recession has sapped demand for U.S. goods, hurting multinational consumer-products companies such as Coke, Gillette Co. and Procter & Gamble Co.
Soft overseas demand and the collapse of global commodities markets--keeping overall inflation low--have made it harder for many firms to boost profits by raising prices.
And in the United States, with unemployment at a 28-year low, firms have to compete for workers by offering better wage and benefits packages. Rising compensation costs further erode profits.
Some companies are reacting to the squeeze with layoffs. Boeing Co., for example, recently said it will eliminate a total of 48,000 jobs by 2000 through layoffs and attrition. The aerospace giant blamed slumping demand for its exports, particularly in Asia.
“Corporations are very much stock-driven and, if profits are weakening, they feel they’ve got to do something now,” said economist Paul Kasriel at Northern Trust in Chicago. “If you can’t raise prices, about the only thing you can do is lay off people,” he added.
Even so, Kasriel said he does not expect layoffs to spread broadly through the economy next year. Rather, he said, demand for labor will finally start coming into sync with supply, which is creeping forward relatively slowly.
Some market theorists say that, despite weaker profits, high stock valuations are justified by low interest rates. As lower rates make bonds relatively less attractive, the theory goes, investors gravitate toward stocks, and the demand makes them pricier.
Kasriel said that while that may be true in general terms, investors should also ask why interest rates are falling.
“If they are falling because demand is falling, that doesn’t help you much,” he said. “After all, interest rates fell during the Depression.”
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(BEGIN TEXT OF INFOBOX / INFOGRAPHIC)
Dwindling Sales
Many U.S. companies this year are struggling with weak sales because of depressed demand for U.S. exports and a lack of pricing power in the domestic market. Past and estimated future annual sales growth for the Standard & Poor’s list of 400 major industrial companies:
1998: No growth
2000: 3.0%
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* Estimates
Source: Lehman Bors.
