Good News and Bad News on Earnings and the Fed

Though not so positively manic as it was earlier in the year, it's hard to argue the market isn't pretty darn moody these days. One day sunshine, the next day rain, and the major indices cut a jagged path through the charts without really going anywhere.

Yet given what's going on in the economy, the market's ups and downs may be (for once) completely rational. On the positive side, there are signs the economy is slowing, and that means that the Federal Reserve's tightening regime may be drawing to a close. Nearly all the Fed watchers on Wall Street now reckon the Federal Open Market Committee will not hike rates at its meeting next week, and there is a growing body of economists who think there will be one more tightening this year.

The end of rate hikes, or the whiff of the end of rate hikes, is typically a positive thing for the stock market. Higher rates mean higher yields, making bonds an attractive investing alternative and sapping money out of equities. That gets reversed when rates stop rising. Moreover, when the Fed goes on hold companies don't have to worry about a higher cost of capital.

But then, of course, there is the other side of the story. If the Fed is close to going on hold, it is because the economy is slowing. And going hand-in-hand with a slower economy are slower corporate profits. Something to worry about.

Warning: Warnings Ahead

Nor does it help that we are in the midst of warning season for the second quarter, the time when companies that will not meet analysts' earnings expectations confess their sins. True, fewer companies than usual have warned this go-round, according to earnings tracker I/B/E/S. But many of the confessors have been high-profile companies, and many have specifically blamed a slowing economy for their inability to meet estimates. (Honeywell (HON Quote), which warned Monday, is the most recent example.)

It's important, though, not to get too dour on earnings during warning season. Companies always seem to be blaming their misfortunes on external conditions. Yet often enough, those conditions don't seem to be hurting their competitors. Caveat investor.

"In the next few weeks, we'll get a disproportionately negative view of earnings," says John Manley, equity strategist at Salomon Smith Barney. "Earnings have peaked, but they've peaked on a rate-of-change basis."

Or, to put it in English, earnings are still growing; they're just not growing as fast as they were. According to I/B/E/S consensus analyst estimates, second-quarter S&P 500 earnings will grow by about 17% pro forma over last year's second quarter.

"We may have some positive surprises, so that number may have some upside potential," says Joe Kalinowski, equity strategist at I/B/E/S. It will not be so hot as the first quarter's 24%, but high teens ain't bad. And the quarters to follow don't look so shabby, either. Third-quarter earnings are expected to come in at 18.5% and the fourth quarter should grow by a further 16%. Who is it that thinks a slowing economy is going to have an impact on profits?

Top-Down vs. Bottom-Up

Well, economists, for one. It's important to remember that those I/B/E/S numbers are bottom-up -- they come from Wall Street analyst estimates.

"Top-down forecasts of profits see more slowing than the bottom-up [forecasts] see," says Chase Securities senior U.S. economist Jim Glassman. "The bottom-up guys will be lagging because they sort of see a reversion to the norm. They're not as well equipped to measure a macro slowdown."

That may seem a little harsh, but think about what's going on in retail land. Even though the S&P 500 has been slowly recovering, retail stocks have seen continued declines. One big reason for that is a slowing economy means slower consumer demand -- fewer people in the shops. And, in fact, sales have been slow for last month and a half (or the first half of the second quarter for most retailers, whose quarters end a month after everyone else's.)

Yet Kalinowski hasn't seen any real downward revision activity among the analysts. "A lot of the analysts are just taking a wait-and-see approach," he says. Waiting for what?

Even if earnings do slow more than analysts expect right now, it may not necessarily be a bad thing for the market, says Manley -- if in fact the end of the Fed tightenings is in sight. (Yes, that is a big if.)

"Given the choice of good interest rates or good earnings, I'll take good interest rates every time," he explains. He argues that earnings matter more for sector rotation -- when they turn up investors should go into more cyclical areas, and when they turn down you should switch into growth companies with steady earnings streams.

"Inevitably, earnings just don't matter for the market," says Manley. "For stocks they matter a great deal, but not for the market."