Investors’ Attention Will Be on Earnings

Investors may decide this week whether improving corporate earnings pack enough punch to warrant higher stock prices--or at least not lower prices.

Second-quarter earnings will dominate the business headlines this week, as the reporting season kicks into high gear.

Operating earnings for the blue-chip Standard & Poor’s 500 companies, in total, are expected to show modest year-over-year growth in the second quarter, according to Thomson First Call and other earnings trackers.

That would be the first increase since the fourth quarter of 2000--testimony to the severity of the profit crunch brought on by last year’s recession, even though by many other measures it was one of the mildest recessions in U.S. history.

Major companies expected to report results this week include IBM, Intel, Apple Computer, Citigroup, Bank of America, Merck and Eli Lilly.

The stock market has been weighed down for the last two months by the wave of corporate financial scandals. Major market indexes, including the S&P; 500 and the Nasdaq composite, last week fell to five-year lows. The Dow industrials sank 7.4% last week, the biggest one-week decline since the markets reopened after the September terrorist attacks.

The Dow closed Friday at 8,684.53 and is down 13.3% year to date. The S&P; 500, at 921.39 Friday, is down 19.8% this year, and the Nasdaq index, at 1,373.50, is down 29.6%.

Second-quarter profit reports should at least remind investors that the economy is growing again, analysts note.

But after two years of relentless declines in the share prices of many firms, investors are more sensitized to stock valuations. And by historical yardsticks, the average blue-chip stock’s price-to-earnings ratio remains above average, despite the long bear market.

The S&P; 500 P/E, based on operating earnings estimates for this year, still is about 19, according to Thomson First Call. The historical average is about 14.

“People want to see a lot of earnings now” to justify stock prices at current levels, said Richard Bernstein, investment strategist at Merrill Lynch & Co. in New York.

But he expects the recovery in profits to be “muted and elongated,” for a number of reasons: lack of corporate pricing power, rising wages, weak demand in many industries and the accounting conservatism many companies may adopt in the aftermath of the financial scandals.

On the positive side, the dollar’s slump against the euro and the yen in recent months is expected to help earnings of U.S. exporters.

Also, “companies have cut costs dramatically, as reflected in huge write-offs in 2001 and strong productivity growth,” said Edward Kerschner, strategist at UBS Warburg in New York. “Even some companies with dismal sales are posting big earnings gains thanks to cost cutting.”

Nonetheless, Thomson First Call research chief Chuck Hill warns investors against becoming too optimistic, even if second-quarter results are substantially better than expected.

“Earnings in the third and fourth quarters likely will fall far short of the very ambitious expectations” of analysts, Hill said.

Analysts’ average estimate for the year-over-year gain in blue-chip companies’ third-quarter earnings recently stood at 16.5%, Hill said. Expectations for the fourth quarter stood at a 28.8% gain. But those estimates have been declining rapidly in recent weeks as analysts reconsider the economy’s growth potential in the second half, given the slowdown in the second quarter in key sectors.