Profits Poised to Surprise Again

By E.S. BROWNING The stock market's strong rally is facing its next test as companies gear up to announce third-quarter earnings that, while still weak, will very possibly be better than investors expect. Earnings in the first two quarters of the year that beat expectations helped propel the market's recovery, and the prospect of a repeat has even some bears wondering if they have been too pessimistic. Morgan Stanley investment strategist Jason Todd, one of the few remaining bears on Wall Street, told clients last week that the stock market is looking stronger than he thought and won't tumble, as he has been predicting, at least through the end of the year. "We think equities will now trade above" his previous target for this year, Mr. Todd said in his report, "in large part because earnings will be higher than we previously anticipated." Until now, Mr. Todd had been predicting the market would fall 14% from today's level by the end of the year. Now he is telling clients that the Standard & Poor's 500-stock index -- which is up 54% from its March 9 low -- is likely to rise marginally between now and year's end and could be up as much as 15% before it gets into trouble. That, keep in mind, is the bearish view. One big reason for the market's continued strength is that expectations were so low for the economy and corporate earnings that the market was able to rise even on modestly good news. "If you are expecting to lose a dime and you lost a nickel, you are a winner," says senior analyst Howard Silverblatt at Standard & Poor's. Expectations remain low. Analysts forecast a 25% decline in third-quarter profits for companies in the S&P 500 compared with a year ago, not counting charges and special items, according to Thomson Reuters. When the quarter began, analysts had been forecasting a drop of 21%. For makers of industrial materials, analysts now forecast a 68% third-quarter profit drop. The expected profit decline for energy companies is 64%, for industrial companies, 45%, and for technology companies, 15%, Thomson Reuters says. The one area where expectations are bubbly is at financial companies, whose escape from death is forecast to result in a 60% year-on-year profit gain. The other bright spot is consumer-discretionary stocks, makers of appliances, cars and other things consumers can easily delay purchasing, whose profits are expected to rise 16% compared with a year ago. The parade of better-than-expected news began in this year's first quarter when S&P 500 profits fell 36%. Analysts had expected worse, so 65% of companies exceeded forecasts, according to Thomson Reuters. The market's rebound has made stocks more expensive relative to their earnings, meaning investors are betting earnings will rebound from their current low levels. Above, traders leave the New York Stock Exchange after the closing Thursday. In the second quarter, although profits fell by almost a third, 73% of companies produced results that were less bad than expected. That tied the first quarter of 2004 for the highest percentage of companies beating estimates since Thomson Reuters started tracking such numbers 15 years ago, and it helped propel stocks still higher. Many people now expect a high percentage of companies once again to do less badly than the analysts forecast. Early results back that view. While only 16 companies have reported third-quarter results so far (these are companies operating on skewed fiscal calendars), 11, or 69%, have exceeded analyst predictions. "Once again, we will see a lot of companies beating estimates" as the earnings season gets going in earnest in October, says Jeffrey Kleintop, chief market strategist at brokerage firm LPL Financial in Boston. Mr. Kleintop thinks that this time, sales are going to be an even bigger surprise than profits. Sales have been slow to recover as consumer spending has remained muted. Companies have been holding up profits by cutting costs. Now, as the recession shows signs of ending, he and others think sales could surprise the analysts, although sales still are likely to be down from a year ago. Stronger-than-expected sales would boost profit margins and give the stock rally fresh fuel. This would also be a welcome sign that earnings are being driven by customer demand and not cost cutting. Companies aren't giving much guidance, Mr. Kleintop says: "They are keeping tight-lipped in hopes that they will beat estimates and get a further boost in their stocks." The market's rebound has made stocks more expensive relative to their earnings, meaning investors are betting earnings will rebound from their current low levels. Based on average earnings over the past 10 years, the price-to-earnings ratio of the S&P 500 has risen to 19 this month from 13 in March, according to Yale economics professor Robert Shiller. On average, the ratio is 15 to 16, so it has moved to above average in that short time from below average. Mr. Silverblatt at S&P says companies in the S&P 500 suffered a staggering sales decline during the 12 months through June -- a total loss of $1.15 trillion, or 12%. They suffered double-digit percentage declines for three quarters in a row. The earnings picture will likely improve further in the fourth quarter, if only because last year's fourth quarter was so bad. Analysts expect fourth-quarter profit declines in only four of the 10 S&P sectors, according to Thomson Reuters: energy, industrials, utilities and health care. For the first quarter of 2010, analysts forecast a profit decline only in telecommunications and utilities, and the drop is expected to be only 2% to 3%. That optimism has some people worried because the higher expectations will come as the government is pulling back on its efforts to stabilize the finance system, and stimulus spending will be slowing. "There is maybe more trouble ahead as we look to the second half of 2010. I am urging clients, while the sun is out now, to benefit from it and get more risk in your portfolios" -- and then be ready to hunker down some time next year, LPL Financial's Mr. Kleintop says. Write to E.S. Browning at jim.browning@wsj.com