Investors Look to Earnings for Picture of U.S.

A suddenly nervous Wall Street wants proof that the economy is as good as its hype.

Rattled by some surprisingly downbeat economic news in recent days, investors are looking to this week’s second-quarter earnings reports to support the bullish case for the U.S. expansion.

That case wasn’t helped last week, when a stream of technology companies warned that quarterly results would fall short of expectations and major retailers said that June sales were disappointing.

The data compounded concerns raised a week earlier by the government’s report on June employment trends, which pegged job creation for the month at less than half what was anticipated.

By Thursday, benchmark stock indexes had fallen to six-week lows, with the Dow Jones industrial average sliding to 10,171.56.

The market got a modest lift on Friday, however, after General Electric Co. declared this “the best economy we’ve seen in years” and said its second-quarter profit beat analysts’ average estimate as sales jumped 11% from a year earlier.

Indeed, many analysts say concerns about the economy are overdone.

“Most indicators suggest that a robust expansion is continuing,” said Michael Darda, an economist at investment firm MKM Partners in Greenwich, Conn.

The optimistic view is that the nation is merely experiencing a hiccup caused partly by stubbornly high energy prices.

The latest monthly survey of business economists by Blue Chip Economic Indicators, reported over the weekend, projects real U.S. gross domestic product growth of 4.5% this year, down just marginally from the 4.7% estimate last month.

For the stock market, the risk is that a sharper economic slowdown could derail corporate earnings growth, in turn eroding the key underpinning for share prices.

Investors already are facing the likelihood that year-over-year profit growth is decelerating -- a natural occurrence as an expansion wears on, said Kenneth Shea, director of equity research at Standard & Poor’s in New York.

“Earnings can’t grow at 25% or more forever,” he said.

Lately, it has seemed as if they could: Operating earnings for the blue-chip S&P; 500 companies jumped 28.3% in the fourth quarter of 2003, then 27.5% in the first quarter of this year.

S&P; 500 earnings are expected to rise 20% in the second quarter, based on analyst estimates tracked by data firm Thomson First Call in Boston. If many companies beat estimates by as much as they did in the previous five quarters, the actual profit gain could again top 25%, Thomson First Call said.

Despite profit warnings last week from some software companies in particular, the overall tally of U.S. companies that have pre-announced their results shows no significant swing to bad news, Thomson First Call said. In fact, there has been a steep rise in the number of companies with good news.

Through Friday, 542 companies had warned of a shortfall in second-quarter results, a 5% increase from the number of warnings at this time a year ago.

By contrast, 358 companies have said they expect to beat expectations for the quarter, up 42% from the number a year ago, according to Thomson.

If second-quarter results overall are significantly better than analysts’ forecasts, investors may begin to bet that third- and fourth-quarter results also could far surpass estimates. That could generate more excitement about stocks and lure new money into the market.

For now, year-over-year profit growth for the S&P; 500 companies is expected to drop to the 15% range in the current quarter and in the fourth quarter, Thomson data show.

“If [an economic] slowdown is going to come, it’s going to come in the third quarter,” said Tom Hanson, portfolio manager at Pacific Global Investment Management Co. in Glendale. He cited seasonal factors and the belief that key economic stimuli -- low interest rates and federal tax cuts -- have “worked their magic already.”

Hanson said the stock market could continue to languish into early fall as investors “re-value” companies in anticipation of a tougher climate for profit growth.

Analysts say the major question facing Wall Street is a perennial one: How much of potential future earnings growth already is built into stock prices?

A principal measure of stock valuation is the price-to-earnings ratio, or share price divided by annual earnings per share.

Based on analysts’ estimates of S&P; 500 earnings over the next four quarters, the index’s P/E is about 16, according to Thomson. That is well below the 20-plus P/Es that reigned at the last bull market peak, in 2000.

Jim Paulsen, chief investment strategist at Wells Capital Management in Minneapolis, said he considered a P/E of 16 to be a relative bargain, given his view of the economy’s prospects.

Many money managers say they agree that the overall market P/E doesn’t appear to be expensive. But when they search for individual stocks it’s tough to find true bargains, some say.

Shares of certain insurance firms and home builders are all that Scott Black, head of Delphi Management Inc. in Boston, can find in the “cheap P/E” market bin, he said.

Black said he liked the business outlooks of many industrial companies as the economy grows. But within the S&P; 500, the average industrial stock is priced at about 18 times estimated earnings for the next four quarters, based on Thomson data.

“You can’t pound the table for those stocks now,” Black said.

Many analysts also warn that if interest rates continue to rise, history suggests that stock P/Es would face downward pressure -- because investors usually reduce what they’re willing to pay for earnings growth as yields on bonds and other fixed-income assets offer more competition.

All of this means there’s a lot riding on how healthy second-quarter earnings turn out to be, and on how companies characterize their prospects for the rest of the year.

Paulsen said he believed that there was plenty of room for investors to be pleasantly surprised, particularly given the recent pullback in stock prices.

“I think there is a high level of pessimism that has more to do with where we’ve been for the last four years than where we’re going” in the economy, he said.

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Reuters was used in compiling this report.