When corporate earnings have been climbing at a double-digit rate for a historic 18 quarters in a row and are projected to climb at close to 10 percent in the next year, it's tough to sing the blues.
And most of Wall Street is not. The consensus for the next year is that corporate profit growth will slow but continue to climb, along with a slower-growing, but still sound, economy.
Yet, as profit growth projections cool to 9.7 percent in 2007 from about 15 percent this year, some strategists are warning investors to be careful about expecting too much from the stock market.
"The risk lies with a slower economy," said Standard & Poor's chief investment strategist Sam Stovall.
Goldman Sachs strategist Abby Joseph Cohen, who expects the Standard & Poor's 500 index to climb 10 percent next year as earnings rise 6 percent, is nevertheless warning investors to expect more volatility in the stock market in 2007.
Of course, volatility, when it's downward, means investors can get hurt if they haven't come to grips with diminished earnings expectations.
Citigroup strategist Tobias Levkovich complained in a recent report that investors, buoyed by the recent rally, aren't thinking seriously enough about risks.
"Investors seem to want to ignore reality in many ways," he said.
In particular, Levkovich notes that investors have been attracted to appliance stocks, even though historically the shares drop when the housing market is weak. He also has doubts about the widespread assumption that growth abroad and a weaker dollar will benefit U.S. corporate earnings.
While many investors expect overseas sales in Europe and Asia to translate into more U.S. dollars, Levkovich believes "the dynamic is far from clear, since U.S. companies import a fair number of products for resale in the U.S. from their international plants or global suppliers." And even if a weaker dollar helps U.S. exporters, he added, it often takes a year to generate real benefits.
"So one should not expect a near-term earnings boost," he said. "Conversely, a weaker dollar could cut into international growth that has been propped up by exports to the United States. Thus, higher costs to U.S. buyers may eat into sales or margins if foreigners absorb the higher cost in order to retain market share."
Although analysts have been lowering their earnings expectations during the last few weeks, many remain encouraged by seemingly strong earnings recently.
But Merrill Lynch economist David Rosenberg said earnings have not been as strong as they look. He said they are getting a huge boost because they are being compared with the period a year ago, when corporate profits suffered because of Hurricane Katrina. Also, earnings per share are being given a 2.5 percentage point boost due to share buybacks.
When earnings are adjusted seasonally and examined sequentially, the same way that gross domestic product is, a very different picture emerges, Rosenberg said. Earnings for the S&P 500 on that basis have declined 6.5 percent on an annual rate, he said.
"On a sequential basis the profits recession has already started," he warned clients recently. "It's just not evident yet in the year-over-year numbers."
Profit margins have fallen for three quarters in a row, he said. It's a result of slowing productivity, rising labor costs, and the fact that with decreased demand for products, companies cannot raise their prices.
The squeeze on pricing was evident in the recent Institute for Supply Management non-manufacturing and manufacturing prices-paid index, Rosenberg said. For manufacturing, he said, it was at its lowest level since February 2002, and for non-manufacturing it was the lowest since July 2003.
Rosenberg attributes the recent stock market rally to the expectation that the Federal Reserve will lower interest rates. But that alone may not continue to propel the market, and Merrill Lynch strategist Richard Bernstein is warning investors to be cautious, as European and Japanese central banks tighten the supply of easy money by raising rates.
Bernstein is telling investors that as access to cheap money becomes more limited, investors could become less willing to take risks. Some of the attraction of low-quality stocks in areas such as emerging markets could ease. He is expecting investors to veer into high-quality U.S. stocks, AAA-rated corporate bonds and non-U.S. preferred stocks.
Bernstein sees risks in the industrial and commodity emerging-market stocks that have been popular in the last few years. Instead, Bernstein said, opportunities may emerge by tapping the rising consumer markets in developing countries.
For example, Merrill's China strategist Joan Zheng argues that in China people under 27 are becoming more consumption-oriented than investors realize. And Bernstein is suggesting that investors consider opportunities for mortgage lending, credit cards and other consumer finance firms in emerging markets.