Earnings 'Confession' Season May Force Markets to Atone for Rally

Wall Street is about to start hearing "confessions" from corporate America. Just how painful the market's penance will be hinges on whether the faith in a second-half recovery is broken.

Around the ides of June, preannouncements -- when companies let investors know if they expect to miss earnings or revenue expectations -- for the second quarter kick into high gear. Confession season usually disrupts the markets, and the stakes are especially high this time: Wall Street has its heart set, and its bets placed, on an earnings recovery at year-end. That recovery scenario has propelled strapping gains over the past two months: The Nasdaq has climbed 39% since its recent low on April 4, while the Dow Jones Industrial Average is up 18% since reaching a two-year low on March 22.

How bad would the outlook have to be to knock the market off its bullish course? While stocks may have priced in bad news about the second quarter, they are not likely insured against big disappointments on guidance for the second half and 2002, strategists said.

"Long-term forecasts are still really optimistic," said Mark Keller, chief investment officer at A.G. Edwards. If the downward revisions for the second quarter and beyond don't justify optimistic longer-term targets, "this could be the quarter that people stop believing them," he said.

Beyond the Second Quarter

"Analysts and investors have pretty much thrown in the towel on second quarter because of what companies said in March and April," says Thomas McManus, equity portfolio strategist for Banc of America Securities. But the same can't yet be said about the third and fourth quarters -- especially in tech.

"Some investors think recovery means tech companies will be back on track for long-term growth estimates of 30% to 50% by the second half of this year," said Mitch Zacks, vice president of earnings tracker Zack's Investment Research.

However, companies such as Cisco(CSCO Quote) have maintained long-term growth targets while slashing near-term guidance, and their stocks have climbed this spring on hopes of a recovery. Indeed, Cisco recently reaffirmed its forecast for long-term annual revenue growth of 30% to 50%, but said it expected revenue for the fiscal third-quarter ending in July to be down about 30% to $4.7 billion in the third quarter. Cisco Chief Executive John Chambers' did qualify the long-term forecast by saying it would require a "healthy global economy."

Currently, analysts expect earnings for the S&P 500 to start rebounding later this year, predicting a 2.8% decline for the third quarter, 8.9% growth for the fourth quarter and 15.3% growth in the first quarter of next year. However, these estimates are expected to fall further, according to Thomson Financial/First Call. While analysts are slashing estimates at a slower pace than they were just a few months ago, if the current pace of earnings' downward revisions continues, earnings estimates for the S&P 500 still will be in the red for the fourth quarter this year and first quarter of 2002.

The Visibility Issue

Negative news on the third and fourth quarters may not come until the second-quarter reporting season or beyond. "Companies have been very reluctant to provide guidance for distant quarters, and they may be even more so now that stocks are up," said A.G. Edwards' Keller. Unfortunately, a lack of guidance could be equally frightening to investors at this point, reviving concerns that companies have no clear vision of future performance -- no visibility. Visibility became a dangerous watchword in December and March, the most recent confession seasons. As company after company reiterated it had no visibility on future performance, investors worried that the slowdown was far worse than anyone had thought.

If companies do cut into third- and fourth-quarter estimates, the bulls aren't going to be happy at all. "If companies warn on third and fourth quarter, then I expect to see a correction that could bring us down to below 2000 on the Nasdaq, but perhaps not as far as the April lows [of 1638.8]. The S&P 500 could slip back to the mid-1100s" from the high 1200s currently, said McManus.

If the optimists are in fact right and there are more signs of the bottoming the bulls have grown to expect, this "confession season" may thrust stocks higher. "If they give mixed guidance -- nothing wildly optimistic, but nothing that takes the wind out of investors' sails, the market could still give the companies a buy," said McManus. "But more optimism on the outlook for the second half would cause a rally."

Indeed, early data on second-quarter preannouncements indicate that there is a bit more positive news than at this time last quarter. According to earnings tracker Thomson Financial/First Call, positive preannouncements account for 20% of the total early guidance, compared with 17% at this time last quarter. And in terms of total market capitalization , the firms issuing negative preannouncements account for 13.6% of the total market cap of the companies Thomson Financial/First Call covers, compared with 17.4% at this time last quarter.

Of course, these numbers come from early in the season. The next few weeks will tell if the markets have to repent for the springtime rally.