Investors fear some earnings will skid
Indeed, a big reason why stocks are off to a bad start this year is because many investors suspect that U.S. businesses won't make as much money this year as analysts think. If so, stocks will likely fall to reflect the new economic reality. Despite rallying Wednesday, the Standard & Poor's 500 is off 4 percent in 2008.
Analysts predict that nine of 10 S&P 500 sectors will post double-digit profit gains in '08, says Thomson Financial. They expect full-year '08 growth of 16.1 percent. The optimism comes even though profit growth turned negative in the third quarter for the first time since 2002 and is projected to be negative again in the final three months of 2007.
Some investors are questioning whether even the mid-single-digit profit growth expected in the first two quarters of '08 is doable. That means the fourth-quarter earnings season, which got its unofficial start Wednesday when Alcoa reported its results, is even more important. If companies don't give reasonably rosy '08 outlooks, watch out, says Gary Kaltbaum, money manager at Kaltbaum & Associates. "If they start lowering their numbers, the market isn't going to be happy."
Kaltbaum says that the market is vulnerable if stocks outside the battered financial and consumer discretionary sectors issue downbeat forecasts, as telephone giant AT&T did Tuesday when it warned of a soft consumer business.
The big risk to corporate profitability is the threat of recession, the odds of which are rising because of the fallout from the housing bust, mortgage meltdown and credit crunch. Compounding the angst: Recessions tend to take a big bite out of corporate profits. S&P 500 profit growth has, on average, dropped 20 percent in recessions, LPL Financial says. Such a drop would erode a key market support: cheap valuations. A 20 percent profit slide would boost the market's price-to-earnings ratio to 17 from 13.6.
In recessions dating back to the early 1950s, the S&P 500 has plunged 25.6 percent, on average, from the market peak prior to the recession, says Citi Investment Research. Much of the damage to stocks occurs in the months leading up to the recession as investors start to price in lower earnings, the Citi report shows.
Stocks can avoid a more serious decline if the earnings carnage is contained, notes Bob Doll, strategist at BlackRock. "There is room for earnings disappointments without killing the market. But earnings can't fall 20 percent. If they do, it means we are in a recession."
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