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Bull Case Takes a Hit

Earnings haven't lived up to lofty expectations, putting optimists on the defensive.
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Let's face it, the fourth-quarter earnings season isn't living up to the hype. The belief that earnings guidance would blow away expectations was one of the two linchpins for the bullish case going into 2006, together with the assumption that the

Federal Reserve

would soon stop raising rates. In recent weeks, both shoes have dropped.

One could always argue that firms such as


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(GE) - Get General Electric Company Report



(INTC) - Get Intel Corporation Report



(GOOG) - Get Alphabet Inc. Class C Report

were merely victims of the Street's lofty expectations. They probably were. But a hard look at the broader market reveals that these disappointments weren't confined to high-profile firms.

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A postmortem of the earnings season might be premature, given that roughly one-third of

S&P 500

companies have yet to report. Still, the picture that emerges so far isn't encouraging. Year-over-year profit growth remains strong, at 15.1% so far, thanks largely to the energy sector, according to Merrill Lynch research. The firm says 62% of reporting companies have beaten expectations, slightly above the historical average of 59%, but 23% have missed earnings, also more than the historical average of 20%.

More troubling (for the bullish case) is that, based on companies' guidance and analysts ratcheting down estimates, earnings growth is seen decelerating to 11.4% in the first quarter and 11.1% in the second quarter. That's double-digit earnings growth, but then again, that's still largely because of the energy sector. In fact, energy's earnings growth estimates rose to 53% on Monday from 43% last week, Merrill found.

There's still plenty of time, of course, for all those expectations to be revised upward or downward.

Jim Awad, chairman of Awad Asset Managed and a notorious bull, confesses that the bullish case has been damaged because of the disappointing earnings season and a Fed that will likely hike rates more than had been expected. "We're likely going to be in a vacuum, and we'll slosh around" until first-quarter earnings come in, or until there are new hints about what the Fed might do.

Add to this that geopolitical tensions have helped propel energy and commodity prices much higher, and you've got the recipe for instability in the market, Awad says. On Tuesday, in fact, a perceived easing of tensions in the standoff between Iran and member countries of the United Nations Security Council provided an excuse for a selloff in commodities, which fueled broad market weakness.

Tuesday morning, Chinese foreign minister Li Zhaoxing said China hopes to resolve the issue of Iran's nuclear ambitions through diplomacy. Crude oil plunged $2, or 3%, to $63.09 per barrel, also hurt by expectations of an increase in U.S. inventories, to be reported on Wednesday.

Gold also plunged, losing $19.50, or 3.4%, to $554.80.

Broad indices, meanwhile, were hit by another warning from the housing sector as homebuilder

Toll Brothers

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said orders for new homes had dropped steeply in its first fiscal quarter.


Dow Jones Industrial Average

dropped 48.51 points, or 0.45%, to 10,749.76.

General Motors

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, which announced it has cut its dividend in half, lost 2% and weighed on the blue-chip average.


S&P 500 index

fell 0.8% to 1254, and the

Nasdaq Composite

lost 0.6% to 2244. Tech shares may receive a boost Wednesday, becuase


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posted better-than-expected earnings after the close. Its shares were recently up 1.9% in after-hours trading.

CPR for Stocks

According to Merrill Lynch market strategist Richard Bernstein, part of the misplaced "euphoria" about earnings growth seen in early January is not completely different from what was seen during the tech bubble of the late 1990s. In an evolved twist of the "new economy" concept of the previous decade, he says that today's consensus views older industries as unable to compete with newer entrants.

"Perhaps the best example is that the market capitalization of one internet-search company" -- Google if you hadn't guessed -- "reached more than three times the market capitalization of the entire newspaper industry," Bernstein wrote in a research note to clients.

Maybe the U.S. auto industry is getting crushed by Asian competition. But that doesn't justify the current high expectations for all "new economy" players. Nor does it justify the underperformance of slower-growing mature companies, Bernstein believes.

Expounding on the theme that a slowing economy this year would lead to a return of the performance of these safer large-cap players, the Merrill strategist launched in November a CPR Index (as in cardio pulmonary resuscitation) to identify out-of-favor industries that may start to outperform.

The industries -- the diversified telecom, pharmaceuticals and media sectors of the S&P 500 -- have started to outperform since November, with the exception of media. Telecoms have yielded returns of 4.8% and pharmaceuticals 8.6% through Monday, compared with a 2% gain for the benchmark index. The media group has risen 1%.

Bernstein doesn't cite any specific stocks in those recommended sectors. Awad, however, expects continued M&A activity in the media sector after


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purchase of



, and says

Lions Gate Entertainment


is "a sitting duck" for a potential acquirer.

Meanwhile, with the potential for a profits recession increasing this year, Bernstein believes the outperformance of his CPR Index is only beginning.

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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