Rally’s Test Is in the Earnings
Wall Street’s ebullient new year’s mood will face a big test this week as corporate earnings reporting season swings into high gear.
So far, investors overall have liked the fourth-quarter numbers they’ve seen. Indeed, stock bulls say the market rally this year, coming on the heels of last year’s sharp recovery, is one of the oldest investing principles in action: Profit gains drive share prices.
But as the market keeps rising, some pros are questioning whether the outlook for 2004 earnings is strong enough to justify further gains in stocks. And Wall Street strategists, who are paid to look ahead, are sweating the possibility of higher interest rates this year, which could cool the economy while making bond yields more attractive, stiffening the competition for investors’ dollars.
For now, at least, analysts are encouraged by the recent flurry of upbeat reports on the U.S. economy and corporate profits. As firms such as computer giant IBM Corp. and chip leader Intel Corp. topped Wall Street analysts’ fourth-quarter earnings expectations last week, broad market gains lifted the blue-chip Standard & Poor’s 500 index to a year-to-date advance of 2.5% and the technology-heavy Nasdaq composite to a year-to-date gain of 6.8%.
“The economy is not booming by any means, but the tea leaves are lining up very nicely,” said Gary Schlossberg, senior economist at Wells Capital Management in San Francisco, pointing to improvement in manufacturing, business equipment spending and consumer sentiment. “We’re seeing the clearest evidence yet of recovery.”
Based on the earnings season’s early tally, fourth-quarter profits could be headed for their biggest year-over-year gain in more than a decade, according to Chuck Hill, research director at earnings tracker Thomson First Call in Boston.
Of the 66 members of the S&P; 500 that reported earnings through Friday, 41 beat analysts’ expectations, Thomson First Call said. When reporting season is over, Hill expects the companies whose stocks make up the index to post overall growth of 26% from a year earlier based on results from continuing operations. That would be the seventh increase in a row and the biggest percentage gain since the third quarter of 1993.
More important to forward-looking investors, executives have guided analysts’ estimates upward for 2004 as well.
For the first quarter, analysts expect profits for members of the S&P; 500 to advance an average of 13.7%.
For all of 2004, the early line calls for growth of 13.2%. Both targets have climbed modestly since the start of the year.
This will be a busy week for earnings reports. Prominent companies slated to report include Johnson & Johnson and General Motors Corp. today, Starbucks Corp. and EBay Inc. on Wednesday, AT&T; Corp. and Southwest Airlines Co. on Thursday and oilfield services provider Schlumberger Ltd. and consumer product conglomerate Fortune Brands Inc. on Friday.
Investors and analysts will be eager not just to see the company numbers but also to read between the lines and to hear executives offer their business outlooks.
On Friday, shares of Juniper Networks Inc. rocketed 30.5% after the communications gear maker blew away Wall Street analysts’ estimates for sales and earnings in the fourth quarter and the company lifted its guidance for the first quarter.
The firm, whose stock more than doubled in 2003, is benefiting from robust demand for products such as routers that direct voice-over-Internet traffic, and analysts even credited its rosy outlook on the industry with helping boost shares of rival Cisco Systems Inc. by 7.3% on Friday.
In light of the market’s powerful rally, however, investors have been quick to express disappointment and sell stocks to lock in gains when earnings reports have been deemed good but not good enough.
As Nasdaq rose to its highest close in more than two years last week, shares of tech firms Intel, Apple Computer Inc. and Yahoo Inc. sagged or stayed flat despite their solid profit reports.
“Companies have to keep beating the estimates impressively, so that the earnings grow into the high share prices,” said Steve Colton, manager of the Phoenix-Oakhurst Growth & Income fund in Scotts Valley, Calif. “Here we are back in early 2000, with some stocks up to ‘bubble’ price-to-earnings ratios.”
P/E ratios offer a snapshot of a stock’s valuation. They measure share price relative to either trailing or expected 12-month earnings per share, and the higher a stock’s P/E ratio, the more investors are paying for their piece of a company’s profit stream.
Before the market crash of 2000, P/Es jumped as investors went hog wild for stocks, “pricing in” continued boom times. Currently, the P/E ratio for the S&P; 500 is 21 based on estimates for 2003 profit -- lower than the bubble-era peak but higher than the historical average of about 16.
Worried portfolio managers say they are seeing other reminders of the crazed, late-1990s bull market.
Shelly J. Meyers, executive vice president and portfolio manager at Pacific Global Investment Management Co. in Glendale, which runs mutual funds and separate accounts for wealthy investors, said she was hearing that Intel slumped in after-hours trading Thursday because it failed to meet its “whisper number” -- the unofficial earnings target that supposedly in-the-know traders bandy about in online chat rooms.
“I’ve hardly even heard that phrase ‘whisper number’ since the bubble years,” Meyers said. “When you start getting that type of analysis, you have to think certain areas of the market are frothy.”
“As a citizen on Main Street, I’m not concerned about the economy, but as someone who manages a portfolio, I’m a little concerned about these valuation levels,” added Meyers, who runs the Pacific Advisors Multi-Cap Value fund.
For Meyers, the question is how investors will react psychologically when the stock market, which has been on an almost relentless climb since the prewar days of last March, inevitably stumbles.
“There are plenty of people licking their wounds from the [2000-’02] bear market, and if we start to get a correction it will be interesting to see how they respond. Will they say, ‘Oh my God, we’re back to the bear market all over again,’ or will they figure, ‘This is a healthy correction and valuations are a little more reasonable now’?”
As to when the market finally hits a correction -- usually defined as a loss of at least 10% -- that appears to be anybody’s guess.
“All the experts on CNBC are saying we’re overdue for a correction,” Colton said. “And when everybody says that, the market just keeps going up. It has a way of always surprising people.”
