Why investors aren't impressed with profits
NEW YORK—When it comes to happy surprises on Wall Street, it's hard to get better than this.
U.S. companies made more money in the first three months this year than almost anyone expected. As earnings reports roll in, they're beating the estimates of stock analysts at a rate not seen in more than a decade.
Yet stocks have languished. The Standard & Poor's 500 index has fallen about 2 percent in April. So why aren't investors impressed?
For starters, earnings season has just begun. The real test is the next two weeks, when more than 300 companies in the S&P 500 report. Apple, the most valuable company in the world, reports Tuesday.
Topping estimates is no great feat. Publicly traded companies do it almost every quarter. They tell analysts to expect a number the companies know will be low. Then they can enjoy a "pop" in their stock price when -- surprise! -- they clear the hurdle.
And this quarter, it's not much of a hurdle. Just a month ago, companies got analysts to expect first-quarter earnings to grow so little you'd need an electron microscope to spot the rise -- just 0.5 percent.
"People aren't as excited as they would be if the estimates hadn't been taken down," says Uri Landesman, president of Platinum Partners, a hedge fund.
Still, some beats are impressive. Yum Brands Inc., owner of Pizza Hut and Taco Bell, turned a profit of 96 cents per share, trouncing the 73 cents expected by Wall Street.
Of every 10 companies that have reported first-quarter results, eight have posted higher profits than Wall Street analysts had estimated, according to S&P Capital IQ, a financial research firm.
That's the highest ratio of "beats" since 2001. In the fourth quarter of last year, the figure was less than six in 10.
Thanks to surprising results in the past two weeks, S&P 500 companies are on track now for earnings growth of 4.3 percent over the first quarter of 2011.
They're growing across industries, too. Analysts had expected seven of the 10 industry groups in the S&P to post lower profits than a year ago. They now think only three will -- telecom companies, utilities and materials makers.
Here's a look at what the higher profits portend.
WILL THEY PUSH STOCKS UP?
Maybe, but only if investors believe future numbers are heading higher, too.
For all the upbeat reports, investors tend to buy and sell stocks based less on what companies earned in the past than on what they're likely to earn in the future. And the outlook is OK, not great.
After a 11 percent increase last year, companies in the S&P 500 are expected to grow earnings 7 percent in 2012, according to S&P Capital IQ. Just six months ago, Wall Street was expecting a 12 percent jump for this year.
The good news is that lower expectations don't always push stocks down. In the first three months this year, analysts slashed estimates for first-quarter profits, and the stock market had its best winter since 1998.
There even have been periods when earnings barely budged and stocks soared. In the five years through 1986, the S&P nearly doubled while earnings slipped 2 percent.
Sometimes stocks rise because investors get more comfortable with the idea of buying stocks generally, and they're willing to pay more for each dollar of profit -- even if those profits are expected to grow more slowly.
And sometimes stocks fall even if profits grow faster. Chalk it up to less confidence about the future or perhaps higher expected inflation, which erodes investing gains.
The upshot: Investing is more complicated than just looking at past profits or guessing, even correctly, future ones.
"What's driving stock prices? Is it the beat rate, the forward guidance, a European recession forecast or the sovereign debt crisis?" asks Sam Stovall, chief equity analyst at S&P Capital IQ. "The answer is, Yes. They all do."
WILL HIGHER PROFITS HELP THE ECONOMY?
As with stocks, profits have a curious, sometimes counterintuitive, impact on the economy.
Unexpectedly strong earnings don't necessarily translate into surprising economic strength. Consider that profits have surged since the Great Recession ended in 2009, even as the economy has struggled to recover. That's because companies made profits mostly by slashing jobs and cutting costs.
The economy, helped by a modest rise in consumer spending, is expected to grow about 2.5 percent this year, up from a sluggish 1.7 percent in 2011.
But in 2010 and 2011, the economy stalled after getting off to a strong start. And a string of disappointing economic reports this month is raising fears of another midyear slowdown in growth.
"The economy is gradually getting better," says Josh Feinman, chief global economist at the investment firm DB Advisors, part of the Deutsch Bank Group. "But it's kind of a stop-go pattern. It's somewhat frustrating, somewhat maddening." He doesn't see "a whole lot of linkage" between corporate earnings and the economy's performance.
WHAT ABOUT PROFITS FOR THE REST OF THE YEAR?
If analysts expected little this past quarter, they're not much more optimistic for the current quarter, either. They expect profits to grow just 2 percent for the three months that end June 30. Then they're expected to rise nearly 6 percent in the third quarter, followed by an impressive 16 percent in the last three months of the year.
Some Wall Street pros aren't buying it.
"It's loaded into the back half -- flat and then a big jump," says Brian Lazorishak, portfolio manager at Chase Investment Counsel of Charlottesville, Va. "I don't think it's going to play out that way."
David Kostin, chief equity strategist at Goldman Sachs, is equally dour. He points out that the profit margins, or how much profit companies get out of each dollar of sales, are starting to flatten, as they usually do in a recovery before dropping fast.
The pattern is intuitive: Companies reach a point where they can't squeeze any more additional work out of their staffs, and other costs start rising, too.
What's unusual is that Wall Street analysts expect those margins to stop flattening, then hit a new peak of $9 for every $100 in sales by the fourth quarter. In the late 1990s, Kostin says, margins rose after stalling. But that was the only time in the past 40 years.