With the stock market in the throes of correction, investors are wondering how bad the damage will be. Is it just a pullback in what is destined to be a stellar year on Wall Street, or is the bull market about to get the horns? Stocks are heading into a light week, with the second-quarter earnings season winding down and many traders focused on the beach. Those still at their desks face some difficult questions. At first glance, things look great in corporate America. Balance sheets are in decent shape, shares are being repurchased, and stock valuations are low relative to bonds. The S&P 500 has now officially enjoyed 13 consecutive quarters of double-digit growth. With earnings from 95% of its companies in the books, the S&P looks headed for year-over-year profit growth of 11.9% in the second quarter, according to Thomson First Call. That marks a decline from the 25.3% pace set in last year's second quarter; nevertheless, it's an impressive trend that should continue. Growth in the third quarter is now expected to be 16.1%, down from last year's 16.8%, and fourth-quarter earnings are expected to rise 13.6%, down from 19.7%. Meanwhile, economists are expecting growth in the economy to pick up in the back half of this year. So, given all that, why is the Dow Jones Industrial Average still sporting a loss for the year, down 2%, while the Nasdaq Composite is down 1.7%? (The S&P is the sole breadwinner among major indices, up a measly 0.7% for 2005.) A closer look reveals some unsettling circumstances surrounding recent earnings success. For one, the energy sector remains the main growth driver in the mix. Remove energy's 42% improvement from the equation, and second-quarter profit growth falls to 8.4%. And this situation appears increasingly consistent with the rest of the year.
Since July 1, growth estimates for the energy sector have nearly doubled for the third quarter, from 21% to 42%. For the fourth quarter, the figure is up from 3% to 21%. What's driving the recent exuberance? You guessed it -- the market's public enemy No. 1: Texas tea. Crude oil futures have surged to new record highs over the summer, nearing the once-unthinkable $70-a-barrel mark last week, and a growing chorus of speculators are expecting prices to keep climbing. While soaring crude prices may provide a nice goose to earnings growth, they have a very different effect on consumer spending, which is the economy's main growth engine. So far, all the cautionary talk about oil's negative effects on consumers has been only that. In fact, the retail sector just handed Wall Street another stellar quarter last week, with earnings growing a better-than-expected 13.6%, up from 12.6% at the beginning of the week. But even with all that upside, retail stocks plunged, with the S&P Retail Index down 2.5% for the week, because a whopping 19 companies lowered expectations for the rest of the year based on disappointing sales trends. "It appears that energy prices may finally be having a bit of an impact on the consumer," Michael Sheldon, chief market strategist with Spencer Clarke, says. "We'll be watching any report that deals with consumer spending closely." Of course, most economic indicators deal with consumer spending at some level, but these days, one area of particular interest is housing. Consumer spending strength has been powered in recent years by a wave of refinancings in the low interest rate environment, while the real estate market has soared in value. Any slowdown in housing could precede a slowdown in consumer spending. On Tuesday, the National Association of Realtors is expected to report that sales of existing homes slowed to an annual rate of 7.25 million in July, down from 7.33 million in June. On Wednesday, the government is expecting to report that new-home sales slid to an annual rate of 1.325 million from 1.374 million.
"Interest rates are still relatively low, which helps the real estate market. But, anecdotally, I can say from my own experience that houses are sitting on the market longer these days, and the sense of urgency from potential buyers has lessened," says Robert Pavlik, chief investment officer with Oaktree Asset Management. "They're not feeling so much pressure to make a quick decision. It indicates to me that we may be reaching a top in the housing market. I think this is probably at least the initial phase of reaching the top." Also Wednesday, the government is expected to report that orders for durable goods declined by 1.2% in July, after a gain of 1.4% in June. Economists expect the Labor Department to report Thursday that initial unemployment claims totaled 314,000 in the week ended Aug. 20, compared to 316,000 the previous week. The Conference Board will also report the results of its Help-Wanted Index in July, expected to stay flat at 38. Federal Reserve chairman Alan Greenspan is expected to weigh in on economic conditions Friday from the Fed's annual conference in Jackson Hole, Wyo. His comments will coincide with an update on its Consumer Sentiment Index from the University of Michigan. Economists expect the final reading of the index for August to match the preliminary reading of 92.7. That marked a decline from last month's reading of 96.5. "We've been expecting this sort of scenario to unfold for some time with the drumbeat of interest rate increases from the Fed," says Ken Perkins, president of Retail Metrics. "Now, we may be seeing the leading edge of this start to take effect. Retail sales were weak in July. Lower-income consumers are definitely feeling a pinch here, and the question is whether it's going to drift up into middle-income consumers."
Perkins noted that third-quarter earnings estimates for the retail sector plunged from 15.2% to 13.1% after last week's round of guidance lowering. Despite these worries, most portfolio managers are sticking with an optimistic view of the stock market, at least for the rest of the year. "I still see upside for stocks for the rest of the year," Sheldon said. "In 2006, the economy and the stock market may run into a bit of trouble due to rising interest rates and energy prices, lower profit margins, and a slowdown in the housing market and consumer spending. "We're not looking for a complete collapse in the equity markets," he adds. "But things will have to slow down."