The Earnings Question

Expectations are still too high, but will that hurt stocks?


You may have missed it amid all the noise in financial markets right now, but it's earnings season. Nobody expects it to be a pretty one, but the real question is what all those company reports will say about expectations for next year and beyond.

Throughout the summer, a slowing economy and unexpected trouble in the credit market meant expectations for the next few quarters at several U.S. companies were probably a bit overblown.

Then in September, dislocated credit markets sent equities dropping like a stone and the government scrambling for a rescue plan. All the while, Wall Street analysts appeared a bit shellshocked, largely leaving their earnings estimates unchanged even as obvious problems mounted.

The good news is things haven't been awful in the third quarter. As of Friday, with fewer than 100 companies reporting, a bit over half have beat estimates, a fifth matched, and the rest underperformed.

"It's not that bad," says Nick Raich, director of equity research at National City. He's predicting earnings declines of about 6 percent for the quarter, with the worst in financials. Not terrible, but those numbers aren't the ones that move stocks.

"Third-quarter numbers are holding up OK, but nobody cares about that," Raich says. What they do care about is what 2009 will look like and where consensus estimates are just too rosy. There, analysts are playing catch-up, but they aren't done yet.

According to Charles Schwab, fourth-quarter results are still expected to rise 47 percent. If that seems high, it is, and everyone knows it. Analysts are expected to slash forecasts heavily in the coming weeks. For 2009, Raich says, Wall Street is predicting the S&P 500 at about $95 a share—or about 10 times earnings as of Friday. He reckons they should be closer to $65—a 30 to 35 percent haircut that would put price-to-earning ratios closer to 15 times earnings, near historical averages for the S&P.

Merrill Lynch analysts, who've gotten even more bearish lately, predict a 14 to 16 percent drop in third-quarter earnings, and an 11 percent drop for year-over-year 2008 results (that's below consensus of a 3.3 percent drop). As for a rebound, Merrill sees just 7 percent earnings growth for '09 compared with a rosy 20 percent consensus estimate.

So, while the price-to-earnings ratio for many stocks looked better as prices dropped last month, it's the "E" in the P/E that's coming down now, and picking the point where earnings look convincing and prices start to rebound will be tough.

Historically, stocks bounce back while earnings expectations are still falling. Stocks usually bottom 8.4 months ahead of a floor in earnings growth (going back to 1949), Schwab says, but unfortunately, this time may be different because of the disruptions caused by the credit crisis, and anyone willing to start forecasting higher earnings in a recession isn't likely to win a lot of followers.

The economy matters too, and all the problems in credit markets are starting to spill over into earnings. As David Malpass of Encima Global noted recently, "These problems have expanded into jobless claims, consumer credit, and retail sales. We expect sharp new weakness in nonfinancial corporate earnings as the recession deepens."

Even after we emerge from the current recession, earnings could still face headwinds that make the kind of double-digit gains we've seen for the past several years unattainable.

"You're seeing an environment where earnings and consumption are going to pull back but will continue to be muted in the future," says Stephen Wood, a portfolio strategist at Russell Investments. "When we do recover [earnings], growth rates for the economy, business, and the consumer will be lower than they have been in previous recoveries."

Until early 2007, U.S. firms enjoyed several years of double-digit earnings growth above historic earnings expansion of about 8 percent or so. That sort of return would've earned you a downgrade in a lot of industries over the past several years. Now, Wood says, investors should get used to a world where 8 percent could be the upper end of the range for a lot of companies.

Corrected on : Update on 10/20/08: Stephen Wood is a portfolio strategist with Russell Investments, formerly Russell Investment Group.