One More Decline, Then Hope for Earnings

10/12/2009 1:00 pm EST

Focus: MARKETS

Sam Stovall

Chief Investment Strategist, CFRA Research

Sam Stovall, Standard & Poor’s chief investment strategist, says third-quarter earnings may be weak, but then things start improving dramatically next year.

The third quarter is probably the most important of all four, as it helps investors either maintain their optimism towards their full-year forecast—and give share prices an end-of-year boost—or causes them to adjust their year-end expectations, and trigger a sell-off in stocks.

Standard & Poor’s equity analysts now project a 10% year-over-year decline in third-quarter operating earnings for companies in the S&P Composite 1500, which consists of the large cap S&P 500, MidCap 400, and SmallCap 600 indices.

Four of the ten sectors in the 1500 are currently projected to post earnings advances. Consumer discretionary companies should see the largest percentage gain, rising 117% from the third quarter of 2008 on easy comparisons, continued cost cutting, and the removal of General Motors from the index. Financials are projected to record their third straight quarter of higher earnings, after [reporting] five successive quarters of losses.

Earnings declines will remain quite prevalent, led by energy’s 74% drop, followed by a 65% expected decrease in materials earnings and a 36% contraction in industrials’ profits.

Energy’s shortfall can be partially blamed on tougher comparisons, as oil prices fell drastically after the oil bubble burst amid the severe global recession. Also, natural gas prices touched a seven-year low and aren’t expected to rise materially until 2011.

Companies in the S&P materials sector also felt the sting of contracting global demand in general and the slowdown in demand from China in particular. The earnings shortfall for the industrials group is likely due to the continued decline in real gross domestic product (GDP) here in the US and abroad.

In the past year, US GDP shrank 5.4% in the fourth quarter of 2008, 6.4% in the first quarter of 2009, and 0.7% in the second quarter of 2009.  However, we expect a 2.4% expansion in third-quarter GDP. We think this economic recovery won’t likely be spelled with either a capital or lower-case “V,” but rather an elongated “U,” since we see real GDP growth of only 1.6% for all of next year.

Of the 143 industries in the S&P 1500, 87 (61%) are projected to report year-over-year earnings declines. In all, 94 of the 143 (66%) industries are expected to record either losses or year-over-year declines in operating results.

But “less bad” has been the rallying cry for several quarters, and this one is no different. The expected 10% decline for the S&P 1500 in the third quarter, combined with an improvement expected in the fourth quarter, should lead to a 7% gain in operating results for the full year. Moreover, S&P equity analysts don’t think the earnings improvement will end with the new year; they currently call for a 37% advance in 2010.

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