A Few Earnings Warnings Do Not an Ugly Quarter Make - TheStreet

A string of negative earnings preannouncements have spanked the major indices in the past week.

Last week, consumer-products giant

Procter & Gamble

(PG) - Get Report

, computer-services provider

Electronic Data Systems

(EDS)

and Big Mac-and-fries vendor

McDonald's

(MCD) - Get Report

issued profit or revenue warnings, helping deflate an earlier relief rally on the first round of cool economic data since the

Federal Reserve began raising interest rates.

Then, Monday, software company

Citrix

(CTXS) - Get Report

cut its second-quarter earnings estimates to half of what Wall Street expected, helping trigger the

Nasdaq's

2.8% drop.

Coming on the heels of cool economic data, the recent warnings sparked jitters that the

Fed's

interest-rate hikes will take an ugly bite out of earnings this quarter.

Ugly. That can't be good. But things may not be as bad as they look.

While a possible slowdown in consumer and business spending and an unfavorable currency environment in Europe could cut into earnings in certain sectors, the total number of negative preannouncements is still relatively low, and preliminary consensus estimates for the second quarter remain strong, say strategists.

According to a report by

I/B/E/S

, 61% of preannouncements have been negative this quarter compared with 80% historically, while 22% have been positive, compared with 10%.

Strategists admitted that second-quarter

S&P 500

earnings would not meet the first quarter's spectacular numbers, estimated to round out to 25% year-on-year once the season finally trickles to a close. But they generally agreed that this quarter probably would top 20%.

And considering how far into the current economic cycle we may be, anything near 20% still looks pretty good, said Alan Ackerman, market strategist at

Fahnestock

, and Chuck Hill, director of research at

First Call/Thomson Financial

.

Of course, exactly where we are in this 10-year economic cycle is debatable, but many economists thought last year's third quarter was going to mark the peak for earnings.

It Ain't Over Yet

Unfortunately, negative second-quarter earnings preannouncements are always heaviest in the last week of June and first two weeks of July, said strategists, so there should be more to come.

"The next three weeks tend to bring forth the disappointments," said John Manley, equity strategist at

Salomon Smith Barney

.

Positive earnings surprises are typically left for last because companies like the price momentum that upside earnings surprises generate. Companies that expect to miss earnings estimates want to surprise shareholders as little as possible, however, so they tend to give them as much warning as possible.

But in a market plagued by interest-rate worries, downside preannouncements aren't taken too well, no matter how far in advance they are issued. In this kind of environment, even last quarter's spectacular upside surprises don't always help.

"People are more sensitive to negative ones right now than

they were last year because they are worried about the impact of the Fed's actions on the economy, and ultimately on earnings. But the Fed action is really just going to affect 2001," said Hill.

Retail, Consumer Staples -- Watch Out!

Most strategists agreed that retail companies, as well as companies with a substantial portion of revenue overseas, particularly in Europe, many of which are consumer-staples companies, might be forced to issue more negative preannouncements.

April and May

retail sales numbers, both of which came in well below consensus estimates, indicate rising interest rates have cut into consumer spending. Reductions in

Gap

(GPS) - Get Report

and

K Mart

(KM)

last quarter were closely followed by

Costco

(COST) - Get Report

and

Circuit City

(CC) - Get Report

.

Analysts also have been cutting earnings forecasts for

Gillette

(G) - Get Report

,

Coca-Cola

(KO) - Get Report

,

Office Depot

(ODP) - Get Report

and

Sara Lee

(SLE)

, due to unfavorable currency translations, said the I/B/E/S report.

Whether or not a strong dollar will take a bite out of company profits going forward will depend on how well-hedged companies are or how easily they can compensate for revenue losses by cutting costs, said Hill. Gillette recently announced that it expects to miss its previous revenue estimates, but said it planned to make up for this weakness by reducing its advertising costs.

Bad News Isn't Always Bad

In any case, while bad earnings can and will hurt individual stocks, they historically have been good for the broader stock market.

"Earnings don't matter a damn for the market," said Manley of Salomon Smith Barney.

Manley cited postwar (that's The Big One, World War II) gains on the S&P, the majority of which came when S&P earnings were down, as well as the fourth quarter of 1982, which was "phenomenal" for the market and still awful for earnings.

Of course, no one really would complain if earnings stayed strong and the market kicked into high gear.