Few Signs of Change for Second-Quarter Earnings

No, the first quarter wasn't good for corporate America. Nor should investors hold out hope that the profit outlook will improve in the second quarter.

Most companies in the benchmark S&P 500 have reported dismal first-quarter results. With suffering retailers and a few big tech names yet to report, the numbers will get only worse. By the time the results are fully tallied, according to Thomson Financial/First Call equity strategist Joe Kalinowski, earnings will have declined to the tune of 12%, making the first quarter the worst for S&P companies since 1991.

A handful of sectors escaped unscathed. With crude oil staying stubbornly above the $25-a-barrel level, S&P energy companies have seen first-quarter profits grow 72%. Earnings at utility companies, which continue to have a hard time keeping up with demand, grew by 38%. Helped by strong results at aerospace and defense companies, the capital goods sector managed to see incrementally better earnings. Because they generally see demand for their wares in good times and bad, health-care and consumer staples companies like Merck (MRK) and General Mills (GIS) saw improving profits.

But those breaks in the clouds did little to dispel the general gloom. Even without most retailers' results, the consumer cyclicals sector looks particularly grim: Earnings slid 45%. Profits at S&P tech companies fell by 38%, while communications companies saw earnings slip 26%. Hardest hit were transportation companies. Caught between rising energy costs and slowing demand, they saw earnings plunge 58%. Basic materials and financial companies also saw declines.

Always Look on the Bright Side...

Investors, however, don't appear particularly interested in the quarter that was, and have chosen instead to focus on improving prospects in the quarter to come. In the last month, all of the major indices are higher, most notably the Nasdaq, which has hopped more than 30% off its low. Nor is this enthusiasm without reason. Besides the Fed's surprise rate cut of March 17, Wall Street has been treated to a steady stream of data that suggest an economy on the mend. Consumer spending has held up remarkably well, home sales and new home construction remain robust and most U.S. companies (tech is an exception) have cleared out excess inventories with surprising speed. Last week's report that gross domestic product rose by 2% makes it seem pretty unlikely that the U.S. is on the verge of recession, and if the April jobs report this Friday comes in OK, the case for a hard landing will be pretty much shut.

Yet while there is light at the end of the tunnel, U.S. companies have some more tunnel to get through before they get to it.

"There's a fair chance that the second quarter could be the weakest of the year and a fair chance that it could represent the bottom in terms of earnings declines for most industries," says Salomon Smith Barney senior economist Steven Wieting.

While a tougher job market hasn't led to the outright consumer retrenchment that had been feared, it looks as though consumer spending will continue to decelerate. Business investment will probably take another hard knock. While companies' lean inventories should mean that GDP growth will remain somewhere in the 1%-to-2% range, a pickup in demand will be necessary to get corporate profits into the positive column. Compounding the problem, comparisons are going to be very tough. In the second quarter last year, GDP grew by 5.6% and companies in the S&P saw earnings grow by 15%. In absolute terms, it was the best quarter ever for corporate profits.

Submerging S&P 500 earnings, year-on-year change

Source: Thomson Financial/First Call

Currently, company analysts expect that S&P 500 second-quarter earnings will fall by around 11%, according to First Call. The contours of that decline are pretty similar to what we saw in the first quarter: The things that have done poorly continue to do poorly; the things that have done well continue to do well. This makes sense. The results of cyclical industries like tech, retail, basic materials and transportation are highly dependent on the ups and downs of the economy.

Peaks and Valleys

Whether further economic deterioration will faze investors is an open question. The current mindset among Wall Streeters seems to be that the market is "looking across the valley" and focusing on a rise in earnings in the second half. There's a general feeling that consumer spending will grow and the economy will grow with it. Earnings growth at many companies would lag behind such a pickup in the economy, because many businesses will curtail spending until they're comfortable that the recovery is real. "I expect profitability to turn around sometime in the second half after the overall economy has picked up," says Lehman Brothers economist Ethan Harris.

Even if one believes in buying cyclical stocks now in anticipation of an earnings recovery half a year out (and this is a point of contention on Wall Street), figuring out which ones to buy poses a bit of a problem. Times of economic duress separate the wheat from the chaff. Well-run companies are able to quickly trim excess inventories and excess capacity, leaving them lean and well positioned to benefit from a rebound in demand. They take advantage of downturns by grabbing market share from poorly run rivals. "There's a bit more open field ahead for the management team that is best able to execute," says Tom McManus, equity portfolio strategist at Banc of America Securities. "An economic rough patch creates unsurpassable barriers for marginal companies, creating less competition for the better companies when business starts to improve."

But there is a difference between a good company and a good stock. Stocks of higher-quality companies tend to underperform peers when the profit cycle picks up. "Let's say there are two companies in a sector: the obvious survivors and the potential failures," says McManus. "The potential failures will be cheap because the risk of buying the wrong stock and losing everything is high. The obvious survivors will be expensive, because lots of investors will put money in them to avoid disaster. When the environment begins to improve, the companies that will see the biggest change in their own environment will be those that barely survived."

Here is a case where investors may have jumped the gun. Take retail, for instance, a sector whose worst time appears to be still ahead. Lately the retailers that are generally reckoned to be the best-run haven't performed as well as lesser players. Wal-Mart (WMT), for instance, has risen 3.6% since March 30, while J.C. Penney (JCP), a company with a penchant for earnings warnings, has risen 27%. Over in tech, the Nasdaq's gain is impressive, but TheStreet.com Internet Sector index's 64% rise over a month is even more so. Investors are showing a lot of faith that the most marginal players are going to make it. If profits were already on the rise, that might be wise. But with more earnings woes yet to come, it seems otherwise.

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