A Dose of Earnings Reality

The Dow clings to 11,000 on sobering news from Alcoa.
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Alcoa

(AA) - Get Report

, the company that launches the quarterly earnings season, didn't live up to expectations. That may not be a bad thing.

On Tuesday, Alcoa's 3.2% drop dragged down the

Dow Jones Industrial Average

, although the weight wasn't enough to drop the proxy below 11,000. The blue-chip index fell only fractionally to 11,011.58. The

S&P 500

also eased slightly, losing 0.48 points, or 0.04% to 1289.69.

Mining company

Phelps Dodge

(PD) - Get Report

likewise slashed its fourth-quarter earnings outlook by more than 75%. Its shares fell 5.2%.

The

Nasdaq Composite

, meanwhile, rose 1.63 points, or 0.07%, to 2320.32.

Apple

(AAPL) - Get Report

helped lift tech shares, announcing it had sold 1.25 million computers and 14 million iPods during the fourth quarter. It also presented its new MacBook Pro and iMac computers, featuring

Intel's

(INTC) - Get Report

Core Duo chip.

But as the bulk of the fourth-quarter earnings season is still ahead, Alcoa's disappointment -- as well as Phelps' -- might provide a healthy offset for investors, who've so far been bathing in positive expectations for both the past quarter and 2006.

That's especially true because this season marks the first in a long time when earnings are squarely at center stage, now that "the focus is somewhat moving off the

Federal Reserve

and onto corporate performance and profits," says Liz Ann Sonders, chief market strategist at Charles Schwab.

So far, earnings expectations have been provided by Wall Street strategists and analysts, not from the companies themselves. As the earnings season unfolds, including the dreaded period of profit-warnings, firms will provide the forecasts upon which a clearer picture of 2006 can be drawn.

Currently, analysts expect earnings at S&P 500 companies to grow 13% in 2006, according to Thomson First Call research. That's down from an estimated 13.3% last year and 20.2% in 2004. But another year of double-digit earnings growth would break the previous record of 13 consecutive quarters.

As things stand, fourth-quarter earnings are expected to have grown 13.4%, which would mark the 10th consecutive quarter of double-digit earnings growth. Since 1950, there have been only two other instances of at least 10 consecutive quarters of double-digit growth: between 1972 and 1974 and between 1992 and 1995.

The end of both periods also marked a peak in the rate-tightening cycle by the Federal Reserve and was eventually followed by weaker economic growth.

Almost everybody agrees that the economy will slow in 2006. Many, such as the Organisation for Economic Co-operation and Development (OECD), predict that the U.S. GDP will grow at 3.5% in 2006, compared with an estimated 3.6% in 2005.

This forecast, however, is based on a housing market -- and consumption -- that cools very slowly, assumptions that may or may not play out. Merrill Lynch chief economist David Rosenberg, for one, expects GDP growth of 2.5% in 2006, which he still expects to represent a "soft landing."

That's still decent growth but it creates a problem for earnings expectations. According to Merrill Lynch research, whenever GDP growth has averaged 2%-3% in a given year, median EPS growth was just 1.6% on average between the years 1947 and 2004.

Bob Doll, chief investment officer at Merrill Lynch Investment Managers, highlighted further problems during his annual predictions presentation in New York on Tuesday. On the one hand, his team projects that the economy will grow at 3% in 2006 (higher than Rosenberg's forecast) but that this will still take down earnings growth to 7%.

"A slowdown in consumption and the absence of a gargantuan advance in energy profits" will lead to the decline, in addition to slower revenue growth, cost pressures and limited pricing flexibility for most firms, Doll says.

On the other hand, the end of the Fed's tightening cycle is not necessarily bullish for either earnings or stocks, he noted. According to Merrill research, earnings growth at S&P 500 companies has averaged 22.8% in the year preceding the peak of a rate-tightening cycle, since 1966. But in the year that follows, earnings actually decelerated 2.1%, on average.

The economic recovery, earnings growth and gains in stock prices over the past three years have been different, Doll says, because they have occurred as the Fed was tightening rates.

This happened after the economy and the stock market rebounded from the 2001 recession, and the Fed brought down rates to historically low levels through 2003, injecting massive liquidity in the financial system. The Fed then began to lift rates only very gradually in 2004, essentially playing catch up to growth.

Meanwhile, earnings growth -- and some of the stock appreciation that took place even as the Fed continued to tighten -- likely borrowed from future performance, Doll predicts.

This, together with earnings expectations that are running too high, is part of the reason the strategist expects the market to experience a 10% correction, its first in four years, sometime in 2006.

In keeping with TSC's editorial policy, Godt doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He appreciates your feedback;

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