Wall Street worries profits may ease

The present is nice, but earnings growth may be peaking

December 23, 2003|By Josh Friedman and Tom Petruno | Josh Friedman and Tom Petruno,LOS ANGELES TIMES

Corporate America is poised to report its seventh consecutive quarter of profit growth, and perhaps the biggest year-over-year gain in earnings in nearly four years.

But Wall Street's glee about fourth-quarter results is tempered somewhat by fears that earnings growth is peaking. Although it wasn't obvious then, the beginning of the 2000-2002 bear market coincided with the zenith of profit growth in the first quarter of 2000.

This time around, many market professionals don't believe share prices are about to hit a wall. Still, they concede that the expected deceleration in the pace of profit growth next year is likely to make investors more discerning about the stocks they buy.

Fourth-quarter results, which companies will begin reporting in about three weeks, are on track to be robust. Operating earnings (results before one-time gains or losses) of the blue-chip Standard & Poor's 500 companies are expected to jump 21.9 percent from a year earlier, based on analysts' estimates as tracked by research firm Thomson First Call in Boston.

That would be the biggest gain since earnings were up 23.6 percent in the first quarter of 2000.

Profits have soared in the second half of this year as the economy has recovered sharply from the slowdown induced in the first half by the Iraq war. Layoffs and other cost-cutting in 2001 and 2002 have afforded many companies enormous leverage: Any rise in revenue can fall directly to the bottom line.

The earnings rebound has underpinned the stock market's surge this year. The Dow Jones industrial average ended yesterday at 10,338.00, its highest level in 19 months. It's up nearly 24 percent this year.

But Wall Street is supposed to look ahead, not behind. And analysts are projecting much slower S&P 500 earnings growth in the first half of 2004 - about 13 percent, year over year, in both the first and second quarter, according to Thomson First Call.

In part, the percentage gain in earnings is expected to slow next year as each quarter's results compare with this year's improved numbers.

Abby J. Cohen, market strategist at brokerage Goldman Sachs & Co. in New York, says it's a myth that bull markets always top out with peaks in profit growth. Stocks can continue to rally even if earnings advance at a slower pace, she said. "The history of most market cycles suggests that share prices continue to rise when profit growth is moderate and accompanied by moderate inflation," Cohen said.

Other experts say analysts could be too conservative in their profit estimates for 2004, which was true for most of this year. That could mean pleasant surprises for earnings - and stocks - next year.

John Snider, co-manager of the TCW Galileo Large Cap Value stock mutual fund in Los Angeles, is among those who believe analysts may be erring on the low side in their estimates, as they did coming out of the early-1990s recession. That makes it more likely that stocks aren't overvalued and that bargains can be found, he said.

"In 1992-'94, the earnings improvement generally outpaced the consensus, and I think that can continue in 2004," Snider said.

Many investment pros say the market's trend of recent weeks suggests investors are following the usual pattern at this point in the economic cycle: They're looking for companies whose profit growth is expected to accelerate fastest in the next year.

Snider, for one, sees value in industrial and commodity companies that benefit when the economy gets rolling.

The basic-materials sector of the S&P 500 - producers of paper, chemicals and metals, for example - is expected to post a 49 percent gain in earnings growth in 2004, up from 11 percent this year, according to Thomson First Call data.

Many transportation companies also are expected to show strong results next year.

In the technology sector of the S&P 500, overall earnings growth is expected to decline next year from this year, but that reflects big turnarounds in 2003 for a handful of companies. The tech sector still is expected to report a hefty 33 percent jump in profit next year.

The growth picture is less clear for some other industries, such as housing.

Mortgage lender Washington Mutual Inc. warned Dec. 8 that its 2003 earnings would be below expectations because of a fourth-quarter shortfall, as lending slows. The news hammered the stock and made more investors nervous about the housing sector in general.

Homebuilders' stocks, among the market's biggest winners this year, mostly have pulled back from their recent peaks.

"It's not surprising to see an industry group lead for three, six or nine months and then fade from popularity as we get earnings deceleration," said John Bollinger, president of Bollinger Capital Management. "We're at very high valuation levels. That means everything has to come out just right, and every disappointment will be punished severely."

The Los Angeles Times is a Tribune Publishing newspaper.

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