Stock investors fancy themselves a prophetic lot -- always attempting to discount the news to come six months down the road. So as second-quarter earnings stream in as strong as the first quarter's, the season is partially overshadowed by investors' concern about economic growth in the latter part of the year. First-quarter earnings were hailed heroically as investors expected the May 10 FOMC meeting to be the real "one and done" finale. But second-quarter reports are being held to tougher standards as traders attempt to forecast when and how hard the economy might fall. UPS' ( UPS) chief financial officer said Tuesday that the U.S. economy is likely to moderate, which initially sent stocks reeling. His words were the antithesis to FedEx's ( FDX) chief executive's bullish remarks last month that the global economy is going strong. UPS shares finished the day down 10.51%, dragging down FedEx, which fell 0.9%, and the Dow Jones Transportation Average, which dropped 1.8%. With stronger-than-expected consumer confidence data and falling oil prices offsetting the early impact of UPS' disappointment, major averages staged a minor rally late in the day to end near the session's highs. The Dow Jones Industrial Average gained 0.5% to 11,103.71, while the S&P 500 gained 0.6% to 1268.88. The Nasdaq Composite gained 0.6% to finish the day at 2073.90. Still, investors are punishing companies with hints of weaker earnings disproportionately more than they are rewarding those who beat expectations. Tuesday's earnings reports tell the tale. A sample of companies that gave poor guidance and/or missed earnings, included UPS, 3M ( MMM), Legg Mason ( LM), Netflix ( NFLX), Level 3 Communications ( LVLT) and Zoran ( ZRAN), fell between 5% and 28%, and by over 13% on average. Meanwhile, the performance of companies that beat expectations ranged from a 0.2% decline for McDonald's ( MCD) to a gain of 14.7% for SanDisk ( SNDK).
Including McDonald's and SanDisk, a group of companies with strong earnings, such as Texas Instruments ( TXN), U.S. Steel ( X), Nabors Industries ( NBR), AT&T ( T), DuPont ( DD) and Jacobs Engineering Group ( JEC), rose by just 4.5% on average. "The negativity about earnings is not unwarranted," says Thomas McManus, chief investment strategist at Banc of America Securities. Large, diversified companies such as 3M that miss earnings show investors there is "not sufficient excess earnings power in unaffected businesses to offset the disappointment," McManus says. "Markets aren't stupid," agrees Rod Smyth, chief investment strategist at Wachovia Securities. "The markets realize that earnings are 30% above trend." The trend line for S&P 500 earnings going back to 1930 is $60, compared with expected S&P 500 earnings of $81 for 2006, says Smyth. If the market believes Ben Bernanke's forecast for a soft landing in the economy, then the earnings should come down to the mid $70s, he says. But if the landing is a bit harder, S&P 500 earnings are likely to fall back to the mid-$60s; either way, profits are likely to go down. It's largely a question to what degree. A touch of worry may be prudent. Earnings guidance for the third quarter has weakened, relative to the long-term average, according to Thomson Financial. With 40% of the S&P 500 reported, the ratio of negative-to-positive earnings guidance stands at 2.8, higher than the average between 2 and 1. Thomson still forecasts 13.8% earnings growth for the second quarter, and double-digit growth for the third and fourth, but estimates have come down slightly for the second half of the year. Energy is the X factor for earnings growth, as it is for the broader outlook for the economy and inflation. The energy sector is not expected to dominate profit growth over the next few quarters as it has through the past four, says John Butters, analyst at Thomson. That said, results from energy firms such as Nabors and Rowan ( RDC) suggest the sector's earnings growth remains robust.
The materials and financials sectors are expected to drive earnings growth going forward, he says, but much of that is due to comparisons with exceptionally weak quarters last year. "There is some potential risk in some of those growth rates," says Butters. After 12 straight quarters of double-digit earnings growth, investors have clearly grown accustomed to companies beating expectations. So, when marquee names like UPS, Intel ( INTC), and Yahoo! ( YHOO) disappoint, investors get nervous, says Art Hogan, chief market analyst at Jefferies & Co. (After the close, Amazon.com ( AMZN) missed expectations, sending its shares down 10.3% in after-hours trading.) As earnings season continues amid the market's fretting over growth, Friday's advance report for second-quarter GDP takes on heightened importance.