Now It’s Push Comes to Shove for Stock Rally

As corporate America begins reporting third-quarter earnings in volume this week, hopes on Wall Street are high.

And that may pose a challenge: To keep the stock market rallying, companies may have to not only beat profit growth estimates, but also offer a reason to believe that 2004 results will be robust as well.

Brokerage analysts expect companies in the blue-chip Standard & Poor’s 500 index to post average earnings growth of 16.2% in the third quarter from a year earlier, according to data tracker Thomson First Call in Boston.

That would be the biggest year-over-year gain in earnings since the third quarter of 2000, and would be the sixth straight quarter of rising results after profits plunged in 2001.

Analysts’ estimates typically are on the conservative side, so companies are almost certain to beat them in the third quarter, as usual, said Chuck Hill, Thomson’s director of research.

He figures that growth overall for S&P; 500 operating earnings -- profit before one-time gains and losses -- will be about 20% once all companies have reported. The fourth quarter could be even bigger, Hill said, perhaps approaching 25% growth.

Optimism about the booming bottom line has helped drive stocks higher in recent weeks. The S&P; 500 has gained ground in seven of the last nine weeks, leaving it up 18% year-to-date through Friday.

Most major stock indexes last week hit their highest levels in at least 14 months.

But some Wall Street pros caution that analysts and investors may be getting too giddy.

“I’m worried that earnings expectations are reaching unrealistic levels,” Hill said. For now, he noted, analysts are expecting growth in some industries to decelerate in the first half of 2004 from the pace in the second half of this year, partly reflecting that this year got a boost in consumer spending from the federal income tax cut in May.

For the S&P; 500 overall, year-over-year profit growth is expected to drop to about 12% in the first half of next year, based on analysts’ estimates.

Hill said the message is, “Enjoy these great numbers but don’t expect them to continue next year.”

On Wall Street, when earnings growth decelerates investors often become unwilling to bid share prices higher.

Yet some of the big-name companies that reported third-quarter earnings last week provided investors with reasons to expect more good news in the quarters ahead.

Internet portal Yahoo Inc., for example, said profit more than doubled in the quarter, thanks to improved business advertising revenue -- which may signal that the economic recovery is gaining steam.

Alcoa Inc. said earnings were up 45% as aluminum prices rose. And snack-food giant PepsiCo Inc. said results rose 13% on an 8.4% gain in sales, the biggest in more than a year.

Yahoo’s report was especially encouraging, said Sam Stovall, chief investment strategist at Standard & Poor’s in New York.

Yahoo had helped “set the tone” for this year’s stock market recovery with its bullish first-quarter profit report in April, Stovall said. “That’s when, ‘Wait till next year’ [for a profit rebound] became, ‘Next year is here,’ ” he said.

But on Friday, conglomerate General Electric Co. cast some doubt on the strength of the economy.

The company just matched analysts’ consensus third-quarter profit estimate as revenue in its turbine, jet engine and plastics divisions fell.

Year-over-year profit has been down for four straight quarters at GE, which warned Friday that full-year 2003 earnings would be at the low end of analysts’ expectations.

The stock slid 81 cents, or 2.7%, to $29.32 on Friday on the New York Stock Exchange.

In upcoming profit reports, investors will be looking for more signs of rising revenue that suggest stronger business spending as well as consumer spending, analysts say. In recent quarters, earnings growth at many companies was driven by cost cutting. But that can’t sustain growth forever, analysts note.

In theory, any pickup in sales could translate into sharp profit gains because many companies are keeping expenses tightly controlled.

Third-quarter profit growth is expected to be strongest in the energy, technology and financial-services sectors, according to Thomson data.

But energy companies’ earnings, which have been lifted by high oil and natural gas prices this year, are projected to decline next year. And the financial sector’s rate of earnings growth is expected to decrease in 2004 as interest rates rise.

For the S&P; 500 companies overall, full-year earnings growth will be 17% in 2003 and about 13% in 2004, based on analysts’ average estimates.

Yet profit growth is expected to accelerate next year in industries such as health care, heavy industry, basic materials (such as commodities) and transportation, according to analysts’ estimates.

Steven Wieting, economist at Citigroup Global Markets, said the dollar’s sharp decline this year should help industrial companies in 2004 post their first “meaningful” profit gains since 2000, as exports rise.

Many analysts expect the stock market to be led next year by the industry sectors whose profit growth is continuing to pick up.

Yet some money managers worry that the market rally this year already may have lifted share prices to levels that fully reflect better earnings, and then some.

“The offset to the good news on earnings is that stock prices have run up so much,” said Jeffrey Van Harte, manager of the Transamerica Premier Equity stock mutual fund. “We’re starting to see some ‘mini-bubbles’ reminiscent of the late 1990s.”

Van Harte pointed to a Deutsche Bank analyst who upgraded semiconductor giant Texas Instruments Inc. from “sell” to “hold” on Friday, telling CBSMarketwatch.com he was “throwing in the valuation towel.”

“I think that says it all with regard to the current modus operandi,” Van Harte said. “It’s more about momentum than fundamentals, and that inevitably leads to trouble.”

But S&P;’s Stovall argued that valuation concerns are overblown. “We have not come too far too fast,” he said.

Though the S&P; 500 index has risen 34% over the last 12 months from its five-year low on Oct. 9, 2002, historically it has jumped an average of 38% in the first year of a bull market, Stovall said.

What’s more, he said stock price-to-earnings ratios are higher than average, historically, but “not alarming” in a climate of low interest rates. The average P/Es of the major stock industry groups tracked by S&P; are mostly between 15 and 20 based on projected earnings over the next 12 months.

“A lot of people think we’re back to ‘bubble’ valuations, but that’s just not the case,” Stovall said.