Updated from June 24
The best preannouncement season on record finally may be translating into better stock returns for investors, but some analysts worry that the good news won't continue.
For the first time since Thomson First Call started tracking earnings data, positive preannouncements for the second quarter actually have outweighed negative warnings. Indeed, 45% of the 212 companies that have provided previews of the second quarter so far expect to beat expectations, while just 36% expect to miss the numbers. About 19% expect to meet estimates.
The optimistic news has led to the highest upward earnings revisions on record, with First Call now looking for 26% earnings growth in the second quarter, up from just 14% three months ago. In the first quarter, earnings rose 27.5%.
Although the prospect of an interest rate hike by the
and the handover of sovereignty to Iraq have kept investors on edge recently, the
has climbed 4.5% since May 17, and the
is now in positive territory for the year.
Still, some analysts are increasingly concerned about what lies beyond the second quarter. David Joy, vice president of capital markets at American Express Financial Advisors, said earnings growth should slow down in the third and fourth quarters as comparisons become "increasingly difficult."
"The going will only get tougher for corporate operating performance," he said.
First Call expects earnings to rise 14% in the third quarter and 15% in the fourth, a marked deceleration from the first half of the year.
Some companies that have released solid preannouncements have seen little effect on their stock prices, partly because of concerns about whether the gains are repeatable.
chief executive, Craig Barrett, said the firm might be headed for a record quarter in the three months ended June 30. Yet shares have fallen slightly.
has also fallen since it raised its guidance at the end of May. Outside of tech,
failed to generate much enthusiasm after raising its earnings outlook for the second quarter, as investors questioned what the third and fourth quarters would bring.
Jeff Saut, chief investment strategist at Raymond James, thinks earnings estimates for the second half of the year are overly optimistic, given the expected increase in interest rates this year.
"Even a marginal interest rate rise should not only have the effect of contracting P/E multiples but also should cause a like contraction in profit margins," he said. "Plainly, that possibility is problematic for a sustained equity market advance, despite the ever-increasing earnings estimates."
Since the U.S. economy is now finance-based and very dependent on low interest rates, Saut said any rate hike will "produce an economic headwind that acts as a huge brake" on growth. He also noted that earnings estimates for this year and beyond fail to include the impact of stock-option expensing or the effect of correcting "fallacious" pension fund assumptions. He estimates that 93% of the companies in the Russell 2000 and Russell 1000 have stock options in place. If options were expensed, the median company in the two indices would have reported earnings that were roughly 7% lower, he said.
In the fourth quarter, the Financial Accounting Standards Board is expected to adopt a rule that would require public companies to expense the value of stock options. Although the House Financial Services Committee voted to approve a bill that would limit the expensing of options to the top five executives of a company, the bill faces an uncertain future.
Meanwhile, Saut noted that roughly 85% of the S&P 500 companies have defined benefit pension plans that are underfunded to some extent. When pension plans become sufficiently underfunded, companies are required to make cash contributions, and that can hurt earnings.
What's more, Saut said many of these firms still are estimating high rates of return on their pension assets. An accounting quirk lets companies book gains on the basis of assumed rates of return, not the actual rate. "We believe the powers that be will address these option and pension plan issues over the next 18 months, implying that the 2005 consensus estimate for the S&P 500 is too high," he said.
Ed Yardeni, chief investment strategist at Prudential Equity Group, is more sanguine. He believes corporate balance sheets are "in the best shape ever" and said firms have plenty of cash to increase spending and boost profits further.
"Usually, analysts are too optimistic about the prospects for any one year and are forced to lower their numbers as the year unfolds," he said. "Not so this time. I can't stress enough how exceptionally bullish the profits picture is so far this year."
Yardeni said the market's lackluster performance so far and strong earnings growth have pushed the S&P 500's forward price/earnings ratio down to 16 in May from 18.2 at the start of the year. The P/E on the tech sector, meanwhile, has fallen to 21.8, the lowest reading since 1998.
"Short-term concerns about interest rates, inflation, oil prices and Iraq have distracted investors from appreciating the amazing rebound in profits and cash flow," he said. "The market's P/E should rebound later this year, once investors see the light and stop staring into the dark."