Stocks Plod Behind Profits

First-quarter earnings were strong across the board, but the market hasn't fully reflected those gains.
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Last week's stock market run could signal that stocks are finally ready to start posting gains commensurate with Corporate America's 11 consecutive quarters of double-digit profit growth.

Friday's employment report showed that the economy added only 138,000 jobs in April, well below the 205,000 that economists were expecting. These days, slow economic growth is the sweetest music to Wall Street's ears, since the biggest worry on the minds of traders is that the

Federal Reserve

will keep raising interest rates to head off inflation and slow the economy.

Stocks danced to the music, rallying the

S&P 500

up near a five-year high, while the

Dow Jones Industrial Average

approached its record levels from 1999. That said, the S&P is up only 6% so far in 2006, a respectable pace if it continues, but hardly a ringing endorsement of corporate profits on top of last year's paltry 3.2% gain and the 4.4% drip squeezed out of the index in 2004.

The breakdown of earnings growth reported in the nearly completed first-quarter earnings season reflects an economy in the midst of a full-figured expansion. Whereas last year's earnings gains would have lost considerable luster were it not for the goldmine of profit flows from the energy sector, first-quarter results, while still a bit lopsided, are far more balanced. And at this point, the double-digit pace is expected to continue through 2007.

"The earnings results we're seeing are not being reflected properly in stocks," says David Dropsey, a research analyst with Thomson First Call. "It seems like there's a real risk aversion when it comes to U.S. equities these days. It may have something to do with geopolitics or lingering effects from the bubble burst

of the late 1990s, but at some point, something has got to give."

With 83% of the companies comprising the S&P on the books, Thomson First Call estimates that first-quarter earnings grew 13.9%, matching the pace set for the first quarter of last year. The rate also beats forecasts from the beginning of the reporting season for a 12.1% rise. The last of the retail companies have yet to report, but considering the number of companies that have outperformed expectations so far, that figure is likely to climb into the mid-14% range.

Out of the 413 companies that have reported, 68% have beat consensus estimates, 15% have matched and 17% have come in below.

"That's better than the long-term average and better than the past eight quarters," says John Butters, research analyst with Thomson First Call. "Companies have really been beating estimates at an impressive rate."

They're also beating estimates by more than usual. On average, companies are surpassing expectations by 5%, while the historical average for that figure is 3% and the average over the last eight quarters is 4%.

The almighty energy sector remains the fastest grower, with a 36% rise for the first quarter, but that rate marks a decline from previous quarters. In fact, one of the major disappointments of the season came from

Exxon Mobil

(XOM) - Get Report

, whose earnings per share missed estimates by 10 cents.

"That's probably a reflection of how high expectations have become for Exxon Mobil more than anything else," says Butters.

Still, while the energy sector slowed a bit, other sectors picked up the slack. Industrials posted 17% growth, with

Alcoa

(AA) - Get Report

,

DuPont

(DD) - Get Report

and

Phelps Dodge

(PD) - Get Report

beating estimates by a wide margin.

The technology sector also increased earnings at a 17% clip, despite a high-profile miss from

Microsoft

(MSFT) - Get Report

. The software giant reported a slightly weaker-than-expected 16% rise in third-quarter earnings and warned that

heavy spending would hurt results through the year.

Just behind technology was telecom, with 16% growth. The financial sector posted a 10% gain, thanks to blowout performances from

Goldman Sachs

(GS) - Get Report

,

Citigroup

(C) - Get Report

,

Morgan Stanley

(MS) - Get Report

,

Bank of America

(BAC) - Get Report

and

Met Life

(MET) - Get Report

. Wall Street was expecting a mere 3% rise from the sector in early April. Also, the healthcare sector had growth of 11%, after analysts had predicted growth of only 4% a month ago.

No sector suffered a year-over-year decline in its growth rate. The biggest laggards were consumer staples and utilities, both areas that are historically viewed as safe havens for stock investors.

Looking ahead, analysts are ratcheting up estimates for future quarters, projecting that double-digit growth will continue into 2007. All this comes as initial estimates for GDP growth in the first quarter rocketed back from the previous quarter's slump to a robust 4.8%. Consumer spending remains strong despite soaring gas prices and rising interest rates, as evidenced by the better-than-expected

April same-store sales reports from retailers.

"This was a great quarter, and it reinforced the fact that the economic growth story for the second quarter is starting to improve, which is going to reinforce the possibility that second-quarter profits will be better than expected," says Barry Hyman, equity market strategist with Ehrenkrantz King Nussbaum.

Still, Hyman concedes that there are significant risks for the economy in the second half of the year with oil prices above $70 a barrel, gold prices at record highs and interest rates expected to rise.

"This kind of earnings and economic growth probably means the

Federal Reserve will continue to raise interest rates in the months ahead, and, of course, that weighs on stocks, since investors worry the Fed will overshoot and slow things down," says Hyman. "Also, with everything that's going on in the world, there's always the possibility of some kind of shock creating financial turbulence. There could be some kind of disorderly weakness in the dollar, an oil-price shock or a bird-flu scare. Who knows?"

Risk aversion is understandable, considering the ongoing violence in Iraq, the nuclear showdown with Iran, the threat of global terrorism and political turmoil in Washington. But when will stocks finally catch up to Corporate America's streak of double-digit growth?

"What matters now is what are the earnings going to look like for the remaining three quarters of 2006 and the four quarters of 2007," says Hugh Johnson, chief investment officer with First Albany. "Based on the rise in both energy prices and, particularly, interest rates, I would expect the growth rate of earnings in all sectors is going to start to decline. But, that forecast has been wrong before, and it could be wrong again."