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A Taste of the Quarter to Come

SAN FRANCISCO -- If you were too busy trying to figure out how to "regift" that special Don Ho tribute CD you got from your crazy cousin, you might have missed the beginning of fourth-quarter earnings season. Alcoa (AA), traditionally the first Dow component to report, got the ball rolling on Monday.

There are two main concepts Wall Street participants agree on regarding the torrent of earning reports that will be released in the coming weeks. First, fourth-quarter earnings aren't going to be very good.

As of Jan. 2, expectations for S&P 500 fourth-quarter earnings growth vs. the prior year had fallen to 4.5% from 16% in June, according to I/B/E/S International. "And we would not expect the decrease to stop here," Joseph Kalinowski, equity strategist at the firm, wrote at the time. One week later, expected earnings growth had fallen to 4%.

Over at First Call/Thomson Financial, Director of Research Chuck Hill observed a similar, yet more extreme, pattern in earnings expectations for technology firms. The consensus estimate for fourth-quarter tech earnings growth has fallen to 3% on Jan. 5, from 29% at the beginning of October. "Even these huge cuts may not be enough," Hill wrote this week.

Reductions in earnings expectations reflect the broader economic slowdown, itself evinced by the tidal wave of negative preannouncements for the quarter -- up 147% among S&P 500 companies and 145% in the tech sector vs. a year ago, according to First Call. The sliver lining in all the slashing of expectations is that there aren't likely to be many downside surprises by the time the earnings are actually released.

Which brings us to the second main factor Wall Street agrees on for this reporting season: The results aren't going to have much lasting impact on stock prices.

"The warnings have pretty much prepared the Street for all the disappointments that might possibly occur," said Hugh Johnson, chief investment officer at First Albany, which manages about $650 million. "I certainly hope we've moved well beyond the fourth-quarter earnings and that they've been fully discounted."

Translation: The expected weakness in fourth-quarter earnings (and beyond) was reflected in the pronounced declines by stock proxies in the second half of 2000.

Wednesday afternoon, stock indices tumbled initially after Cisco (CSCO) issued some cautious comments -- although not specific to earnings -- at a Morgan Stanley Dean Witter conference. Cisco fell 2.4% to $36.25 but closed well off its intraday low of $33.69. Similarly, the stock proxies rallied back, with the Nasdaq Composite finishing the session up 3.4%. The action emboldened those who believe the worst has already been "priced into" the market.

Don't Look Back

How market averages digest the forthcoming information depends largely on the forward guidance companies give, rather than the actual fourth-quarter results. While true every quarter, this takes on added significance now because of all the uncertainty about the economic environment.

A prime example is the news from Yahoo! (YHOO) Wednesday evening . Yahoo!'s fourth-quarter earnings met consensus, but its shares tumbled after hours as the company's forecast for earnings and revenue for 2001 were far below previous expectations.

"The issue for 2001 is how much of an earnings adjustment still has to occur," said Michael Strauss, market strategist at Commonfund Group, which runs about $26 billion.

The key to whatever additional adjustments are necessary revolves around when the Federal Reserve's easing last week -- and presumed future rate cuts -- will begin to revive the economy.

"The equity market has historically said 'I know the current quarter and next are going to be bad, but the lowering of interest rates will help the cycle six to nine months down the road'," Strauss said. "At some point we get over the hump and look at better earnings cycle for late 2001 or early 2002."

The crux of the issue is whether you believe the Fed waited too long to begin easing, and that a hard landing or even a recession is unavoidable. Or if the central bank's easing signals the economic cycle may have already reached its nadir.

The timing issue is where the aforementioned consensus on Wall Street starts to unravel. More optimistic observers believe the time to strike is at hand. Even if earnings growth doesn't bottom until the first or even second quarter, they say the market will soon begin to rise in anticipation of the recovery that follows. More cynical observers believe a recession is unavoidable, and that investors' faith in the Fed to help revive the economy and thus corporate earnings will prove undeserved.

Notably, others contend the recession talk is overdone and over-hyped and believe the economy will not suffer two consecutive quarters of falling GDP. But it is entirely possible corporate earnings might still suffer a recession of their own. Combine the intense competition that is limiting many companies' pricing power, higher wage and benefit costs, as well as rising energy prices, with a slowing economy, and a deceleration in earnings growth seems almost unavoidable.

A profit recession is the expectation of Thomas McManus, equity portfolio strategist at Banc of America Securities. He predicts S&P 500 earnings will be 5% lower in the first quarter and 1% lower in the second, respectively, than the prior year's results.

"Earnings for the S&P 500 are falling into a frozen lake," McManus said. "Hopefully, we'll be able to climb out the other side by the end of the second half."

For all of 2001, he expects profit growth of just 1.75% vs. the current consensus estimate around 9%, according to I/B/E/S International. (I/B/E/S's Kalinowski believes actual results will be closer to 6%.)

Technology-driven productivity enhancements have allowed earnings to grow faster than sales, as long as sales are growing quickly, McManus explained. But when sales slow, earnings grow significantly slower because "part of the productivity miracle has been replacing people with machines," he said. People can be laid off or asked to reduce their output, but "if you pull a plug on the machines," the cost of capital incurred to pay for those machines starts to eat into profits, he continued.

Still, McManus expects earnings growth to trough in the first quarter and for the market to have a "pretty good" second half. But the strategist wonders how investors will react to what he anticipates will be additional market losses in the first half or 2001 despite Fed easing.

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