Earnings Estimates Still Too Lofty


WHILE WALL STREET’S OUTLOOK for corporate earnings has grown more bearish by the day, the estimates are still not grisly enough.

Analysts have sharply cut their third-quarter and full-year financial profit estimates for companies in the Standard & Poor’s 500 since the summer, finally giving up on the notion that profits will climb much in 2008.

A poll by Thomson Reuters shows that the Street expects earnings to fall 2.3% in the quarter ending Tuesday from a year earlier. For the entire year, profits are expected to remain flat, a big change from the 6.7% gain analysts had forecast in July.

But some are skeptical about even those modest expectations and expect earnings to be down this year by as much as 8%. And there’s little confidence that the 22% gains predicted in 2009 will materialize given the uncertain economy, falling oil prices and the turmoil plaguing financial markets.

“It’s going to be a challenging environment for corporate profits well into 2009,” says Ed Yardeni, chief strategist at Yardeni & Co. “The stock market is discounting a lot already, but for the next 12 months, you can still expect corporate earnings to be in a lot of pain.

There are a few bright spots. Health care and consumer staples remain the furthest removed from the recent financial unrest and should continue to generate steadily growing profits. The rest of Corporate America, however, faces stiff headwinds, particularly financials, technology and industrials..

On Monday, U.S. lawmakers rejected a proposed $700 billion bank bailout aimed at stabilizing the teetering U.S. economy. Crude-oil prices, meanwhile, have fallen sharply since the start of the quarter, offering a much-needed break for industrials and airlines but boding poorly for the global economy.

Big companies are spending less — and buying back less stock — a ripple effect of the credit crunch. Moreover, Europe and other beleaguered foreign economies no longer can be counted on to provide as big a boost to U.S. exporters.

The financial sector, meanwhile, has plunged into a quagmire. The sector’s profits are expected to fall 58% in the third quarter, and drop 45% for the full year.

But the Street sees big year-over-year gains starting next year. In 2009, analysts predict that profits will recover strongly — nearly doubling on average — although those predictions strain credulity as the credit crisis goes from bad to worse.

Much of those gains will reflect favorable comparisons to the financial sector’s dismal performance of the past year. Also the removal of troubled entities from the S&P 500 — including Lehman Brothers Holdings, Fannie Mae (ticker: FNM) and Freddie Mac (FRE) — will no longer weigh on the sector’s results.
Still, experts agree that even if a bailout plan gets approved, the financial sector’s fundamentals remain anybody’s guess.

“Frankly, we do not know what to expect anymore from the financial sector,” says Bill Stone, chief investment strategist at PNC Wealth Management. “The wild card is the bailout.”

All that misery and uncertainty has fed volatility. And investors don’t see it ending soon.

Major stock indexes rebounded strongly Tuesday after suffering steep losses just a day ago, including a 778-point loss by the Dow Jones Industrial Average.

So far this year, the Dow has fallen 19%. The S&P 500 index and the Nasdaq Composite have both declined 21%.

“Once we get this bailout behind us, and the smoke clears, investors will focus more attention on profitability and the economy, and they will realize that things are not that great.” says Jack Ablin, chief investment officer at Harris Private Bank.

Barron’s Online predicted in March (see Weekday Trader, “Don’t Count on a Second-Half Comeback,” March 26, 2008) that consensus estimates for 2008 were too high. And in June we reported that a turnaround would have to wait until next year (see Weekday Trader, “An Earnings Comeback Deferred,” June 24, 2008).

William Rutherford, founder of Rutherford Investment Management, says, “If we get 10% then [2009] will be a good year.” Yardeni sees profits climbing 15% in 2009.

Earlier this month, Goldman Sachs forecast a 14% jump in profits for the S&P 500 in 2009.

Exclude financials, however, and the rest of the index doesn’t look terribly exciting. Goldman expects profits for the nine remaining sectors of the S&P 500 to climb just 4% in 2009.

Recent company news provides little reason for optimism.

Last week, General Electric (GE) cut its third-quarter financial forecast and suspended a stock-buyback program. On Monday, Walgreen (WAG), the nation’s second-largest retail pharmacy chain, posted weaker-than-expected quarterly financial results.

Microsoft (MSFT) warned investors earlier this month that sales of software will likely be hurt by the U.S. financial crisis, heightening concerns for the technology sector. Monday saw another blow when Morgan Stanley and RBC Capital Markets downgraded Apple (AAPL), citing weak consumer spending.

The Street expects profits for the technology sector to climb 8% in the third quarter, and 9% in the fourth quarter. For all of 2008, profits could climb 12%, according to Thomson Reuters.

But analysts have been cutting estimates since July. And Goldman predicts that profits for the tech sector, as well as industrials and materials will fall in 2009.

“Smart management will give conservative guidance for the fourth quarter and we will not get a good look at their opinions about the outlook for 2009,” says Richard Parower, manager of the Seligman Global Technology Fund.

Health care is expected to grow profits 8% this year, well below the 15% gains recorded in 2007, but a rare positive prediction.

And the outlook for the consumer-staples sector has grown more bullish in recent months. Profits are expected to fall 1% in the third quarter. But for 2008, earnings could climb 5%, better than the 3% year-over-year gain expected back in July.

The energy sector, meanwhile, continues to grow profits this year at a rapid pace. But falling oil prices have led analysts to trim their estimates. Profits are now expected to climb 33% in 2008, and rise a much more sedate 7% in 2009, according to Thomson Reuters.

Despite a slowing world economy, foreign earnings for U.S. companies remain a relative bright spot, given the still-cheap dollar, and growth in emerging economies in the Middle East and Brazil remain strong.
Wall Street, however, does not like uncertainty. While oil prices are not expected to revisit earlier record highs, fundamental improvement in the financial sector is a ways off.

So, while the S&P 500 appears relatively cheap — trading at 13.3 times forward earnings, near a 10-year low — that valuation depends on earnings forecasts coming to fruition.

The record of the past year shows even as estimates have been steadily trimmed, analysts still have been too optimistic. That’s why the investors are taking forecasts for 2008 and well into 2009 with more than a grain of salt.