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A stock recovery ... later than sooner

A looming war in Iraq is not the only thing bothering investors. Earnings prospects have deteriorated seriously as forecasts for stronger growth get pushed into the future. By Martin Wolk
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Shaky consumer and investor confidence has driven stock prices back down to near their lowest levels in more than five years, and a potential war in Iraq is not the only thing bothering investors. Despite a glimmer of hope from the technology sector, earnings prospects for many industries have deteriorated seriously as forecasts for robust economic growth get pushed further into the future.

A survey released Friday shows that leading business economists expect corporate profits to grow only 10.3 percent this year, compared with expectations of 15 percent growth just three months ago. That is consistent with estimates by Wall Street analysts, who have steadily downgraded the outlook for 2003 earnings, cutting estimates by an average of 7 percent over the past four months, according to First Call.

The question is whether the declining earnings estimates are caused by a real worsening of business conditions or increasing caution by corporate executives and analysts ahead of a likely war.

James Paulsen, chief investment strategist for Wells Capital Management, is among those who believe that most of the problem is psychological, with war jitters overwhelming signs of small but steady economic improvement.

“I believe the fundamentals are getting better and better (but) we are in a place where the media and investors are not going to accept it that way,” he said.

With the fourth-quarter reporting season nearly concluded, 60 percent of companies actually have exceeded earnings expectations, compared with 56 percent a year ago, Paulsen pointed out. Yet companies were far more optimistic at this time last year, he said.

“A year ago, companies almost had to give an optimistic outlook after 9/11 or they were considered unpatriotic,” he said. “Today they almost have to give a pessimistic outlook or they are considered imprudent.”

Paulsen pointed to recent economic indicators showing improvement, particularly in the manufacturing sector, that he said have been largely ignored by investors.

On Friday, for example, the Federal Reserve reported that industrial production rose 0.7 percent in January, more than double the expectation, although the figure was boosted by automotive output that is not expected to continue. Consumer sentiment, however, fell to a nine-year low in early February as Americans absorbed grim tidings of a falling stock market, rising fuel prices, a tough job market, a likely war and a Code Orange security alert.

With investors riveted to developments at the United Nations regarding a potential war with Iraq, stock prices seesawed Friday before ending on a positive note, giving the market its first winning week in more than a month.

As corporate America has turned cautious over the past six weeks, analysts have cut back their expectations severely for producers of basic materials, utilities, industrial companies and airlines. A surprising and perhaps encouraging exception is the technology sector.

Expectations for earnings from big technology companies have barely budged since Jan. 1, offering a “glimmer of hope,” said Chuck Hill, director of research at First Call. For the overall S&P 500, negative earnings warnings have outpaced positive preannouncments by a ration of nearly 5-to-2, while in the tech sector the ratio has been about 9-to-5, close to the historical average.

Computer giant Dell reported strong earnings Thursday in line with expectations and made no change in guidance, news that was greeted warmly by investors, who pushed up the company’s stock price more than 10 percent Friday.

Ned Riley, chief investment strategist for State Street Global Advisers, pointed out that Dell’s solid quarter came on top of positive reports from other tech giants including Microsoft, Cisco and Intel. The news is encouraging because rising investment in technology is expected to be an early sign of the increased business investment that should lead to improved economic growth.

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“The bottom line is that these companies are making good money in [a] horrible environment,” he said. “The basic business is turning.”

But he understands that analysts and company executives are going to “err on the side of conservatism” as the moment of truth approaches in the U.S. showdown with Iraq.

An avowed optimist, Riley is convinced that by the end of the year corporate America will be breezing through the reduced earning expectations.

“For the longer term investor it’s just another opportunity to put more money into the market,” he said.

Paulsen agreed and said that the downgraded expectations mean that most of the worst-case scenarios already are built into published estimates, meaning there is little downside risk. That may be a hard proposition to accept when federal officials once again are warning openly of a potential terrorist attack on U.S. soil, but Paulsen prefers to focus on what he considers a more likely outcome: no major attack and a relief rally in the stock market.

“It’s been a while since we’ve been so overwhelmed by everything but the fundamentals,” he said.