Slower Growth May Limit Stocks’ Rise

07/26/2007 12:00 am EST

Focus:

Stephen Biggar

Director, Product Strategy, Argus Research Corporation

Stephen Biggar, vice-president of Standard & Poor's Equity Research, says corporate earnings growth is slowing and that may keep put a lid on equity markets for the rest of the year.

The second-quarter 2007 earnings season got off to a rough start, with Home Depot, D.R. Horton, Ryland Group, and Sears Holdings among the companies revealing that housing-related weakness appears to be [doing continued damage to] consumer spending and the consumer discretionary sector.

Meanwhile, Standard & Poor's Ratings Services (which is independent from S&P Equity Research) downgraded some 500 subprime classes of debt totaling $6.4 billion in rated securities, dampening any hope of a swift end to housing- and mortgage-related weakness.

S&P continues to [expect no] real earnings progress in 2007. S&P analysts estimate the S&P 500 index will post only 5% profit growth in the second quarter, a continued deceleration from the 8% increase in the first quarter of 2007.

It is not only the relatively low prospects for earnings growth that are of concern, but rather the components of growth itself. S&P estimates that favorable foreign currency translation will contribute about 2% or 3% to quarterly earnings growth this year, with stock buybacks adding another 1% to 2%. Meanwhile, simple inflation is contributing 2% to 3%.

With earnings growth expected to be only 7% in 2007, these former boosters are accounting for much of the total. S&P analysts foresee [only] 2% [earnings growth] in the third quarter. But the current estimate for earnings growth in the fourth quarter stands at 13%.

While hope springs eternal, fourth-quarter growth estimates may need to be ratcheted down. After all, the "500" posted only 9% earnings growth in the fourth quarter of 2006, after three strong quarters earlier that year. Absent an interest rate cut or significantly lower oil prices, we believe the back-loaded picture and such reliance on a single quarter raises doubts as to whether 2007 full-year earnings growth expectations can be met.

S&P has a year-end target of 1,510 for the S&P 500, with the index already slightly above that level. What gives? Quite simply, we believe the market has gotten ahead of itself and will remain range-bound for the remainder of the year.

S&P continues to recommend a portfolio diversified across different assets and sectors. We continue to advise a 65% weighting in stocks, including 40% in US equities-because stocks continue to look more attractive than bonds or cash at this time.

Based on S&P analysts' target prices, the S&P 500 should hit 1677 by June of 2008. Our recommended sectors are consumer staples, which is tracked by the Select Sector SPDR-Consumer Staples exchange-traded fund (XLY), and health care, which is tracked by the SPDR-Health Care exchange-traded fund (XLV).

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