As the credit-market turmoil has abated, investors have turned their attention back to earnings. They don't like what they see, which could spell more pain for the stock market.
More than 400 members of the Standard & Poor's 500-stock index have reported third-quarter results, and per-share earnings for companies in the index are on track to have fallen nearly 14% from a year ago. That makes five straight quarters of declines, tying the record set in 2001-02.
And it doesn't yet reflect the economic train wreck that began with the Lehman Brothers Holdings collapse just before the end of the third quarter. That collapse set off a global panic that is now materializing in a consumer-spending slump, factory slowdowns and layoffs.
All this will hurt corporate profits. Although Wall Street stock analysts have been reducing their forecasts for future quarters, they still may not be pessimistic enough. As the fourth quarter began Oct. 1, analysts expected earnings for the period to rise nearly 47% compared with weak results a year ago; now they expect 25% growth. They expect 6% growth in the first quarter of 2009, down from a 25% forecast a little more than a month ago.
The average forecast still calls for S&P 500 earnings to rise 13% in 2009, an unlikely outcome if the economy will be in a recession through at least the first quarter, as most economists expect.
The trouble with Wall Street's forecast is that it is a "bottom-up" compilation of analyst profit forecasts for the individual companies they cover. When times are hard, these forecasts are almost always wildly optimistic. They overestimated earnings between 30% and 35% in each of the past three recessions, according to MKM Partners chief economist Michael Darda.
Economists and analysts who forecast earnings with a "top-down" approach, taking into account the broader economy, tend to be more realistic in recessions. They now expect that a poor economy will add to the pain in the financial sector and continue to hurt other industries. Mr. Darda sees earnings falling 13% in 2009 from the current average estimate for 2008, roughly in line with many other top-down forecasters.
Jack Ablin, chief investment officer at Harris Private Bank in Chicago, says the forecast for 2009 "is predicated on a huge rebound in the profitability of financials."
"While certainly a lot of the worst is behind us, I don't see this as a 'v'-shaped profit recovery," Mr. Ablin says.
Financial companies have been a millstone around the neck of the broader indexes throughout the slump. Without them, S&P earnings would be up 10% in the third quarter. The energy sector continues to pull earnings in the other direction, despite the steep retreat in oil prices. Without energy, S&P earnings in the third quarter would be down 27%.
Associated Press
Traders wait for General Motors earnings report on the floor of the New York Stock Exchange Friday, Nov. 7, 2008.
But as the economy contracts, it is hard to avoid the effects. Stripping out both financials and energy, earnings for every other industry are on pace to shrink in the third quarter for the first time since the downturn began. Exclude home builders and auto makers, too, and earnings still are roughly flat from a year ago, the worst performance since the 2001-02 earnings downturn.
Most investors believe aggressive government intervention will keep the recession from getting too deep. If they are wrong, earnings could fall much further than even pessimists expect. Until the contours of a recovery are certain, investors may be less willing to pay much of a premium for corporate earnings. Past downturns, such as in the 1930s, 1970s and 1980s, ended with the S&P trading at less than 10 times earnings.
The S&P trades at about 13 times the top-down forecast for 2009 earnings per share of about $70 for its component companies combined. That is a lower price-to-earnings multiple than after the 1990-91 and 2001-02 earnings downturns, but it still may be too high for some investors.
"I think a multiple above 11 times earnings is silly when you have all of these unknowns and worries about the credit crisis," says Michael Pento, market strategist at Delta Global Advisors. "You can't say these are normal times, so why slap a normal multiple on stocks?"
Meanwhile, corporate profit margins, which hit a 40-year peak just two years ago, may still have further to fall. Now that banks can't use debt to turbocharge profits, their margins will continue to shrink.
Profit margins in other industries peaked later, in the third quarter of 2006, and have drifted downward since. Though commodity and other input costs are falling, the economic mess suggests sales will fall, too, keeping more pressure on margins.
Write to Mark Gongloff at mark.gongloff@wsj.com
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