We’ve spent a lot of time discussing the year over year earnings situation. Indeed, I’ve pointed out the hypocrisy of reporting inflation ex-energy, but reporting year over year SPX earnings with-energy.

Now, we see the NYT has also noticed the impact of the energy sector on the S&P. In the 4th quarter of 2003, and the 1st Q of 2004, energy companies were actually a drag on SPX earnings. That’s no surprise, considering that Oil broke out in January 2004.

Given the recent spate of negative warnings, I think this chart is too optimistic; I believe the SPX year over year earnings improvements ex-energy will be single digits:

click for larger graphic

Nyt_yy_e02fundgraphic

Chart courtesy of NYT

Of course, higher energy prices will also reveal themselves in reduced consumer spending. That eventually gets reflected in earnings: retailers, but also durable goods and entertainment — indeed, all discretionary spending tends to get pinched.

Here’s the Ubiq-cerpt:™

At the start of the year, analysts were predicting a conservative gain of 7.6 percent in first-quarter earnings for the Standard & Poor’s 500-stock index, versus the same period a year earlier. As it turned out, S.& P. profits jumped nearly 14 percent in the first three months of the year.

In April, Wall Street analysts were expecting second-quarter earnings to grow 8.8 percent. Profits grew around 12 percent during the period.

Yet the luxury of low earnings expectations appears to be a thing of the past – and that puts equity prices at risk. In recent weeks – even after Hurricane Katrina struck the Gulf Coast, wreaking havoc on New Orleans and its port – analysts have been lifting their forecasts for third- and fourth-quarter profits.

The consensus forecast for third-quarter profit growth now stands at 17.8 percent, up from 15.1 percent at the start of the quarter, according to Thomson Financial. Fourth-quarter estimates have also shot higher – to 16.5 percent from 12.2 percent in July.

The upward revisions in S.& P. earnings forecasts come as economists have been going in the opposite direction. Many have been reducing their forecasts for overall economic growth for the second half of this year, in the aftermath of Katrina.

The rosy earnings outlook worries some people on Wall Street. "I’m concerned that the numbers may be a bit too optimistic now," said Mary Ann C. Bartels, an equity trading strategist at Merrill Lynch. "We now appear to be in a complete opposite situation from the first and second quarters," she said, when expectations were low and the ability to exceed them was good . . .

Of course, a simpler explanation is that S.& P. earnings forecasts are rising because energy sector profits are expected to shoot through the roof. While higher oil and gasoline prices hurt consumers, as well as companies in a variety of industries, especially transportation, they are clearly a boon to energy-related businesses.

Indeed, at the start of the year, when a barrel of crude oil was trading in the low $40′s, analysts were predicting that earnings among energy companies in the S.& P. would fall 7 percent in the third quarter, versus the period a year earlier.

By early July, when oil prices were hovering near $60 a barrel, third-quarter earnings in the energy sector were expected to jump 21 percent. Energy prices spiked in the aftermath of Katrina and as of Friday the consensus estimate had surged to 73 percent, according to Thomson Financial.

To be fair, it’s not just energy that’s growing, said Mike Thompson, director of research at Thomson Financial. "The reality is, earnings remain strong and the impact of Katrina on S.& P. 500 profits doesn’t look, at least initially, to be tremendous," he said. Mr. Thompson noted, for example, that if you stripped away the energy sector, earnings for the rest of the S.& P. 500 would still be expected to grow 11 percent in the third quarter – higher than the historical growth rate.

Still, when the energy sector is subtracted, estimated earnings growth for the S.& P. 500 has been falling in recent weeks and months. At the start of January, for example, analysts were predicting that S.& P. 500 earnings, aside from those of the energy sector, would grow 15.3 percent for the third quarter. That forecast fell to 14.3 percent at the start of April, and now stands at 11 percent. By that measure, the profit outlook may not be so rosy after all.

Even a marginal increase in negative surprises could disappoint the Street and hurt equity prices, money managers and investment strategists say. Ms. Bartels of Merrill Lynch noted that in the second quarter, nearly 70 percent of companies beat consensus estimates for earnings growth. If positive earnings surprises fell back to the historical average of 59 percent, that alone would disappoint the markets, she said.

THE other unknown is how energy costs are affecting consumers. At the end of the day, consumers are responsible for roughly 60 percent of corporate profits, Mr. Thompson said. And while consumer confidence took a big hit after Katrina, it remains to be seen how consumers will change their spending – if at all – in response to the surge in gasoline prices.

The big test may come later in the year, as winter approaches and households may also have to contend with high heating bills.

Source:
The Problem With Great Expectations
Paul J. Lim
NYT, October 2, 2005
http://www.nytimes.com/2005/10/02/business/yourmoney/02fund.html

Category: Earnings, Economy, Investing

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