The Wall Street Journal-20080204-A Profit Fumble -- or Not-

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A Profit Fumble -- or Not?

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It is right around halftime of the earnings-reporting season, and bulls and bears have much to disagree about.

More than half the companies in the Standard & Poor's 500-stock index have reported their fourth-quarter tally and the headline numbers show a bleak 19.3% drop, according to Reuters Estimates. That double-digit decline, however, largely reflects the huge write-downs by banks and brokerage houses suffering losses tied to bad mortgages. Earnings outside the financial sector are up 11%.

"It's very striking -- nonfinancial earnings are still quite healthy," said Thomas Doerflinger, executive director for U.S. equity strategy at UBS. That strength, he added, "has been fairly broad based." Earnings at technology companies are up 26%, energy earnings up are up 19% and health-care companies are up 18%, he said.

The outlook for 2008 profits, however, leaves room for investors to differ over whether the cup is half empty or half full. First-quarter profits are forecast to rise anemically, 2.6% from a year earlier. That is forecast to be followed by a modest 3.5% rise in the second quarter.

Financials are expected to have another rough time of it in the first quarter, with earnings forecast to be down 18.5%. A week ago, financials were expected to show a 17.3% decline, according to Morgan Stanley's data. Consumer discretionary earnings are expected up 1.2% this quarter, a slimmer rise than the 2.7% forecast a week earlier. In the past week, expectations for materials-producing companies swung to a loss of 2.1% from a 3.5% rise.

For the year as whole, expectations also have been steadily worsening; in the past two months analysts have lowered 2008 forecasts on nine out of the 10 sectors of the S&P 500, according to UBS. Only among energy stocks have earnings forecasts been taken higher. Yet when it comes to the second half of the year, the theme song for stock analysts could be, "Happy days are here again." S&P 500 earnings are expected to be up 20% in the third quarter and 50% in the fourth quarter, analysts said.

If the analysts are right, 2008 would end with earnings up a healthy 16%, according to Reuters Estimates. Based on those estimates, the stock market looks attractive, with S&P 500 companies changing hands at 16 times the trailing 12 months' earnings and 13.6 times projected 2008 earnings. That compares with a 19.4 average price-to-trailing earnings ratio going back to 1988, according to S&P's data.

So which side is right, the bulls or the bears? Much depends whether expectations for later in the year turn out to be realistic. Some have said they are far too rosy.

With the economic outlook deteriorating, the trend has been down in earnings estimates, and analysts still might be behind the curve, as they often are at turning points in the economy. Analysts have been lowering estimates twice as often as they have been raising them. With the government reporting an unexpected decline in employment in January there could be more earnings downgrades to come.

Abhijit Chakrabortti, chief global and U.S. equity strategist at Morgan Stanley, said Wall Street's consensus forecast of about $900 billion in earnings for the S&P 500 for this year is at least $100 billion too high. "Earnings expectations have to come down a lot," he said.

Part of the expected rebound in earnings this year will be a statistical mirage -- a so-called easy comparison with bad readings posted in the fourth quarter of 2007. That is especially the case on financials stocks, where analysts believe big write-downs and losses will be a memory by this time next year.

Forecasts also are banking on the Federal Reserve's interest-rate cuts to give a shot in the arm to the economy, and to financial firms. When short-term rates are low and long-term rates are higher, as is now the case, financial firms often get a boost.

Mr. Chakrabortti has a different read on some of those factors. He expects the dollar to be stable or even slightly stronger over the course of this year as other economies slow, thus creating a drag on earnings. He said balance-sheet strains will put an end to meaningful share buybacks, which have been boosting S&P earnings 2% to 3% in recent years. Meanwhile, he said industrial names and technology stocks will be hurt by the ripples from declining capacity utilization. "We're going to see some big misses on earnings," he said of technology stocks.

While he said Wall Street analysts are overly optimistic on consumer-discretionary companies and financial stocks, he noted most of those names already have been down significantly in price. "We think technology is more vulnerable" because of loftier valuations, he said.

Another big question mark is the outlook for profit margins, which have trended higher for years. The most recent earnings reports provide examples of big companies struggling with margins narrowing and creating a challenge for earnings prospects. McDonald's, for example, last week said higher food costs were pressuring its margins, while Procter & Gamble reported lower margins on higher commodity and energy costs. Energy stocks, a winner for investors in recent years, could face a headwind in refining operations, where margins face potential strains as new capacity comes online as demand for gasoline ebbs.

Some easing of economic activity around the globe could remove some of the upward pressure on commodity prices, but they could stay at levels that will squeeze margins, said MarkOline, head of corporate ratings at Fitch Ratings. "Any margin improvement that companies get is going to have to come through getting more operating efficiencies, but that will put downward pressure on wages and on employment levels," he said.

Mr. Doerflinger, of UBS, said there still is reason to be bullish. Economic growth outside the U.S. will remain strong enough to help offset softening in the U.S., he said. "Companies are saying the foreign business is quite strong," he said.

Shipping company United Parcel Service, for example, is expecting package volume in its domestic business to rise 1% to 2% in 2008. Export volume for its international operations should rise 10% -- the same pace as in 2007, the company said. DuPont, meanwhile, expects continued growth in emerging markets, and United Technologies predicted strong demand in Asia.

Mr. Doerflinger said U.S. corporations are continuing to benefit from the depressed dollar, which makes it cheaper for those outside the country to buy their goods. Goods and services sold overseas also translate into more dollars back home when the currency is weakening. This translation effect added an average of 4.6 percentage points to revenue at large, multinational companies in the fourth quarter, up from 3% in the third quarter, he said.

A final positive trend is stock buybacks, which Mr. Doerflinger said reduced shares on 235 companies he has tracked by 1.7%. That may slow somewhat this year, but still should work in the markets' favor because most companies boast healthy balance sheets, he said. When you add it all up, he said, the outlook is especially constructive for industrial and technology stocks.