First Call's Chuck Hill: Despite Upturn, 4Q Earnings Growth Should Be Viewed on Par with 3Q

And allowing for further revisions to forecasts for 1999's first and second quarters, look for earnings growth to slow in the new year's first half.
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Expectations for fourth-quarter 1998

S&P 500

year-over-year earnings growth now stand at 3.4%, and the reported figure likely will end up at about 4%. That follows respective gains of 3.8% and 3.5% in the first and second quarters of last year and a loss of 3.1% in last year's third quarter.

The fourth-quarter upturn, however, is mainly an anomaly caused by the effects of the

General Motors

(GM) - Get Report

strike (it pulled down third-quarter 1998 by 2 percentage points and added 1 in the fourth quarter), last-minute changes in companies in the S&P (particularly the removal of

Amoco

(BPA)

and the addition of

America Online

(AOL)

) and restatements of fourth-quarter 1997 results for acquisitions (particularly

BankAmerica

(BAC) - Get Report

), which together added almost 1 percentage point to fourth-quarter 1998 expectations.

Also contributing were changes in the dollar that allowed for translating overseas earnings at a higher rate in the fourth quarter vs. the third quarter. This made the comparison between the fourth quarters of 1998 and 1997 and the third quarters of 1998 and 1997 an easier one.

All together, the above factors may have added about 3 percentage points to fourth-quarter 1998 earnings. The net result is that, without these factors, earnings growth in the fourth quarter would have been about the same as in the third.

Looking forward to 1999's first and second quarters, the industry analysts are currently at 9.1% and 13.8%, respectively. On Oct. 1, the estimates were 14.3% and 18.9%, respectively. Given the amount of reductions in the last month or so, it is likely that the final results for both will likely be below the 4% expected for the fourth quarter.

Estimates continue to be sharply reduced for oil, chemical, paper, steel and capital-equipment companies. In addition, estimates for many multinationals in other industries have been reduced, often as a result of negative preannouncements from the companies. Negative preannouncements are already up to 473 and will surely break the record of 526 set for the third quarter of 1998.

While earnings on average are likely to be disappointing for at least two more quarters, there are clearly some bright spots. Consumer-spending-driven industries such as retailing and homebuilding remain strong. Technology is also on a roll. Unlike other industries hit in the first quarter of 1998, technology had an even bigger problem in having to correct the inventory glut in personal computers. But with that now corrected, technology has bounced back strongly. Fourth-quarter estimates for semiconductors were raised substantially during the quarter, software estimates were raised somewhat and, on average, estimates held firm for computers and for communications equipment. The momentum is there for positive surprises in fourth-quarter results and for further improvement in the first half of this year. Other notable areas of strength are long-distance telephone and pharmaceuticals.

However, all these areas of good earnings growth are all commanding high multiples. But then, that is true of the market as a whole. At 27 times 1999 earnings (based on the 4% earnings growth expected by the broker strategists), the market is at a record valuation by a wide margin. Prior to 1998, the post-World War II record had been 18, including periods when interest rates were even lower than today's.

Unless one has confidence that a strong earnings rebound is imminent, it is difficult to believe this multiple can be sustained. It does seem to be ignoring the uncertainties in future earnings, particularly in view of the economic problems in Japan and Latin America, rising imports into the U.S. and cutbacks in capital spending by U.S. corporations.

Charles L. Hill is director of research at First Call, the Boston-based estimate-tracking firm.