Hopes for 2010 Overshadow Weak Earnings Season

By JOHANNA BENNETT MORE ARTICLES BY AUTHOR Investors are looking beyond third-quarter corporate profits for justification that the seven-month-old bull market has legs. LARGE U.S. COMPANIES are expected to turn in a ninth straight quarter of year-over-year operating profit declines for the third quarter. But investor hopes are hinged to the fourth quarter and next year, and these expectations have helped drive up share prices in anticipation. The stock market's seven-month rally suggests that investors believe profits and revenue will stop sliding in the fourth quarter. And they think third-quarter earnings -- expected to fall nearly 25% over last year's third quarter -- could actually beat expectations, at least modestly. Projections for 2009 and 2010, meanwhile, have risen since May. The sectors that analysts expect will turn in solid earnings growth next year are technology, energy, materials and consumer-discretionary companies. "I would never classify third-quarter earnings as good, but there are signs of improvement," says Ashwani Kaul, global head of proprietary research for Thomson Reuters. Still, expectations remain low. Despite an eye-popping shift in direction next quarter, full-year earnings for 2009 are expected to shrink 16.7% from last year, according to Thomson Reuters. In 2010, however, the Street sees profits climbing 26%, the first full-year gain since 2006. Stock indexes already reflect much of those hopes. Though down last week, the Standard & Poor's 500 has climbed 57% above the 52-week low reached on March 9, while the Nasdaq has risen 67% and the Dow Jones Industrial Average has gained 49%. -------------------------------------------------------------------------------- Handicapping Profit Growth Percentage changes reflect year-over-year differences. Sector 3Q '09 4Q '09 2009 2010 (Estimate) (Estimate) (Estimate) (Estimate) Technology -15% 22% -10% 24% Financials 63% NA* 104% 71% Health Care -3% -1% 1% 9% Energy -64% -29% -58% 47% Consumer Staples -3% 3% -3% 10% Industrials -45% -17% -34% 13% Consumer 15% 94% 1% 37% Discretionary Utilities -4% -6% -4% 8% Materials -69% 209% -60% 87% Telecommunications -10% 7% -7% 6% Average Growth Rate -24.6% 193.6% -16.7% 26.2% Source: Thomson Reuters and Standard & Poor's as of Sept. 29, 2009 *Thomson Reuters First Call is unable to calculate growth rates from negative base-year earnings. -------------------------------------------------------------------------------- Now, it's up to Corporate America to meet those expectations. "It's show time for earnings," wrote Ed Yardeni, president and chief investment strategist at Yardeni Research, in a note published Monday. David Rosenberg, the chief economist and strategist at Gluskin, Sheff & Associates, sees a "listless" economic recovery next year. (See Barron's, "A Vote for Bonds Over U.S. Stocks," Sept. 14, 2009.) Recent economic data have provided fodder for both bulls and bears. Most forecasters see corporate profits rising in 2010, though how much is up for debate. Thomson Reuters says the consensus among sell-side analysts for operating profits generated by the S&P 500 is $75.59 a share. But Barclays Capital expects $60 a share next year. And economists at S&P see less than $53 a share in 2010, up 10% over the $48 a share expected in 2009. Even if the economy continues to struggle, year-over-year comparisons remain pretty easy. Companies have started restocking depleted inventories. A weak U.S. dollar and recovering overseas economies will boost foreign revenue. Cost cuts have set the stage for fast earnings growth once revenue starts growing again, an event the Street expects next quarter. Consensus estimates compiled by Thomson Reuters see revenue rising 1.9% year over year in the fourth quarter, and 7.5% in the first quarter of 2010. Oil prices should rise next year, a boon for energy companies that have suffered this year from low prices and weak demand, according to Jerry Jordan, manager of the Jordan Opportunity Fund. Expected to fall 58% this year, profits generated by energy companies will jump 47% in 2010, according to Thomson Reuters. Technology, however, remains a favorite among investors and analysts, with profits expected to climb 24% in 2010. Bill Stone, chief investment strategist for PNC Wealth Management, likes IBM (ticker: IBM) and Apple (AAPL), while Jeffrey Kleintop, chief market strategist at LPL Financial, "expects good news" from semiconductor companies, including Intel (INTC). Other sectors could post far bigger gains. Due to fall 60% this year, profits generated by materials companies will climb 87% in 2010. Meanwhile, profits from financials are seen climbing 71% next year over 2009. New accounting rules put in place earlier this year governing how financial companies account for "toxic assets" have some analysts questioning the quality of those earnings. Also, the industry faces more government regulation and possibly more bank failures. "I would not touch them with a ten-foot pole," says Dirk van Dijk, director of research at Zacks Investment Research. Wall Street is convinced that better days are ahead for the markets and the economy but Barrons.com reporter Johanna Bennett examines some scenarios that could burst that bubble. Debate still surrounds profits for consumer-discretionary companies, seen rising 37% next year. Thanks to rising unemployment, consumers remain tightfisted, opting to save money rather than spend it. Still, Americans have embraced bargain hunting, a boon for discounters such as Kohl's (KSS), Ross Stores (ROST) and Dollar Tree (DLTR). "People aren't returning to their old spending habits, at least not quickly," says PNC's Stone. Of course, a lot can happen between now and the end of 2010, by which time the government will be pulling back on its efforts to stabilize the financial system and stimulate the economy. A "W-shaped" recovery -- where the economy falls a second time before resuming growth -- remains a worry. Cost cutting can't drive earnings growth forever, and if revenue forecasts don't pan out, expect a lot of pressure on equities. And with forecasters looking for as little as $53 a share in S&P operating earnings next year, a price-to-earnings ratio based on those estimates -- 20 -- looks pricey. Still, for now, investors expect a slow but steady climb. -------------------------------------------------------------------------------- Full Disclosure • LPL Financial held 281,543 shares of Intel as of June 30, 2009, according to StreetSight.net. • PNC Wealth Management held 3,276,151 shares of IBM and 973,408 shares of Apple as of June 30, 2009, according to StreetSight.net.