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The Days of Rising Corporate Profits May Be Over, for Now

Sunday, 08 July 2012 03:29 PM

For almost three years, no matter what has rattled the financial markets — a debt crisis in Europe, high gasoline prices, a slower economy — investors have been soothed by rising corporate profits.

The storyline became as predictable as a soap opera's. But when the latest round of corporate earnings starts rolling in this week, look for a twist: Profits are expected to fall.

"China is still slowing. Manufacturing numbers in the U.S. are weak," says Christine Short, senior manager at Standard & Poor's Global Markets Intelligence. "You can only have so many things working against you."

Stock analysts expect earnings for companies in the Standard & Poor's 500 index to decline 1 percent for April through June compared with the year before, according to S&P Capital IQ, the research arm of S&P.

That would break a streak of 10 quarters of gains that started in the final quarter of 2009.

Over recent weeks, a motley collection of chain stores, steel producers and technology titans have warned of slowing profits. They all point to similar culprits — flagging sales to Europe and slower economic growth in China.

Procter & Gamble, the world's biggest consumer products company, cut its profit outlook for the year, blaming sluggish economic growth in China and Europe along with a stronger dollar, which makes U.S.-made goods more expensive abroad.

Ford said it expects to take a hit from European sales and may have to shut an assembly plant. Nike reported a drop in profits and warned of tough conditions in Europe and China. And that's just within the past month.

"You've seen the evidence," says Adam Parker, chief U.S. equity strategist at Morgan Stanley, the investment bank. "A ton of companies have already told you the economy is slowing."

The list of companies that have warned of trouble is long and varied, and includes well-known names such as McDonald's, Cisco, Starbucks and Tiffany & Co.

Add them up, and 94 companies have lowered their estimates for this earnings season, which begins on Monday when Alcoa, the aluminum maker, reports its results. Only 26 have raised their estimates.

Morgan Stanley's research team says the ratio hasn't been that lopsided toward the negative since the summer of 2001, when the economy was in the middle of an eight-month recession brought on by the bursting of a bubble in technology stocks.

Europe's debt crisis has been a problem for nearly three years, but that never stopped companies from reporting record profits quarter after quarter. The U.S. economy appears to be losing speed, but the economic recovery has moved at a fitful pace since the Great Recession ended in 2009. So what makes this time different?

The price of oil and the dollar. Oil dropped 26 percent from the start of April to the end of June, while the dollar rose 5 percent against a basket of major currencies. In a note to clients, Parker called this duo "the worst combination for S&P 500 earnings."

Cheaper oil is usually considered a good thing. By pulling down the price of gasoline, it essentially puts money in Americans' pockets.

It's a different story for Exxon Mobil, Chevron and other oil and gas companies in the S&P 500. For them, a drop in oil prices squeezes profit. And because energy companies play such a large role in the S&P 500, Parker said, their falling profits weigh on the group.

The direction of the dollar matters because U.S. companies rely on overseas sales: Nearly half of all the revenue for S&P 500 companies comes from abroad. When the dollar climbs, it diminishes the value of those foreign sales. Parker found that since 1975, an 8 percent gain for the dollar against major currencies knocked earnings down by 2.6 percent.

To be sure, companies sometimes cut their profit expectations too deeply, a practice that provokes grousing among many investors. They suspect companies of setting the bar so low that they'll soar over it and get rewarded with a roar of applause and a higher stock price.

In early April, companies had talked down their forecasts so much that analysts expected first-quarter earnings to be down 0.1 percent for the S&P 500. A couple of months later, the final figures looked starkly different: Earnings rose 7.5 percent.

That history is one reason many analysts and investors say they believe this earnings season won't be quite as bad as current forecasts. Not as bad, of course, isn't the same as good.

"Could they beat it? Sure," says Bill Stone, chief investment strategist at PNC's asset management group. "They'll probably jump over the bar. But they're not going to set the world record for the high jump."

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Sunday, 08 July 2012 03:29 PM
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