Margin Call: Profitability Views Seem Off

By MARK GONGLOFF Third-quarter earnings reports might drive market action for the next few weeks, starting with Alcoa's results due after the closing bell on Wednesday. But the longer-term stock outlook hinges on the longer-term earnings outlook. Trouble is, Wall Street again might be too optimistic. At the moment, analysts expect companies in the S&P 500-stock index to earn nearly $73 a share, excluding one-time items, in 2010, up 35% from 2009. If these forecasts are right, then the S&P is trading at less than 15 times 2010 earnings, arguably a fair deal. These expectations, however, assume a V-shaped profit recovery that would be the fastest since the advent of the use of "operating" earnings in the 1980s. That V might make sense given the steep earnings decline during the slump. But corporate profits hinge largely on the performance of the broader economy, and at the moment a V-shaped recovery there seems unlikely. Certainly, when it comes to sales, analysts expect a recovery shaped more like an "L," with revenue increasing between 5% and 10% in 2010, according to various estimates, well below the forecast for profit growth. With revenue growth slow, it will take thick profit margins to create the kind of turbo-charged earnings growth analysts expect. The consensus forecast assumes margins of about 8% next year and 9% in 2011, estimates Bill Hester, senior research analyst at Hussman Funds, compared with a long-term average of 6% and the all-time high of 10% in 2007. If 2010 profit margins are closer to their long-term average, then that figure combined with expected revenue growth would leave the S&P trading at something closer to 17 times next year's expected earnings, less of a bargain. The consensus expects profit margins to end this year at nearly 6%. And they often expand after recessions, as companies are slow to hire workers even as sales accelerate. But even if margins do return to 8%, it might not happen quickly. Adding two percentage points to margins has taken roughly two years following the past two recessions, twice as long as the consensus expects. That doesn't bode as well for earnings or, in turn, for stocks. Write to Mark Gongloff at mark.gongloff@wsj.com