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Can earnings growth continue to surprise?

When U.S. companies start to report their quarterly earnings in two weeks’ time, investors will be looking not only for proof of another standout quarter but also for any clues that the two-year upswing in corporate profit growth is beginning to wane.

When U.S. companies start to report their quarterly earnings in two weeks’ time, investors will be looking not only for proof of another standout quarter but also for any clues that the two-year upswing in corporate profit growth is beginning to wane.

For months, a consensus has been building on Wall Street that corporate earnings growth will begin to slow in the latter half of this year, with the second quarter’s results representing the peak in a two-year streak of earnings growth following the recession of 2001.

Earnings growth can hardly continue on its powerful upswing forever, stock market prognosticators note. Year-over-year comparisons will get tougher and a slowdown in growth is inevitable as the Federal Reserve embarks on an expected series of interest rate rises, reducing the flow of cheap credit.

“There’s a feeling that the second quarter was the peak in earnings growth and we will see a deceleration in the second half of the year,” said David Joy, capital markets strategist at American Express Financial Advisors.

“It has some people worried that the market will have a hard time moving ahead this year. But if the economic momentum we are seeing in the data continues into the second half, can earnings growth also surprise in the second half of the year? That’s an open question on Wall Street right now,” he said.

The question is a particularly pertinent one for the stock market, which has spent the last few weeks stumbling around in listless trading, showing no hint of breaking out of its narrow range. Professional investors say traders are on hold until they know the outcome of the Fed’s next rate-policy meeting and the handover of sovereignty in Iraq, both of which take place next week.

A deceleration in earnings growth isn’t necessarily disastrous for stocks, but it has an important impact. As earnings accelerate, riskier, small-capitalization stocks tend to do best as investors take on more risk. But as earnings growth decelerates, investors gravitate toward a more defensive strategy, moving money into more stable, larger-cap companies that show steady but slower growth, such as consumer products makers.

Early indications are that earnings in the April-to-June quarter are likely to be as impressive as in the prior two quarters, when they grew by 28 percent over the year-earlier period, according to research firm Thomson Financial/First Call.

A consensus of Wall Street analysts tracked by First Call has ratcheted up its expectations for earnings growth in the broad Standard & Poor’s 500-stock index from 14.9 percent to 20.4 percent for the quarter. That puts companies in the index on track for a fourth straight quarter of earnings growth over 20 percent — a feat not seen since the Internet bubble period of the late 1990s.

Joseph Cooper, a research analyst at First Call, expects results to be “terrific.” Sixty-four percent of all analysts’ earnings revisions have been upward for the April-to-June period, translating into the highest percentage point gain for earnings estimates on record, he said. “But based on the estimate revisions and pre-announcements we have seen, we think earnings growth in the quarter will end up being as much as 26 percent," he said.

Materials, tech lead growth
The quarter’s best-performing sector will be basic materials, which includes companies that make chemicals, metals and plastics, Cooper said. The sector is benefiting from strong pickup in global demand for products and is expected to see year-over-year earnings growth of 76 percent. The technology sector is seeing similar growth thanks to strength in the semiconductor sector and should post a 54 percent increase in earnings.

Sharply higher oil prices have boosted the energy sector too. “This is the big swing factor in earnings,” Cooper said. “When we started the quarter, energy company profits were expected to be up 3 percent, but now the estimate for earnings in the sector is up to 43 percent. That accounts for most of the change we have seen in overall earnings growth.”

Analysts generally predict earnings growth will shift to the low teens later this year and into the single digits in 2005. But quarters after quarter, results from companies have surpassed expectations, leading Cooper to suspect that the surprising trend may continue.

“We entered year with the idea that earnings growth would decelerate, and analysts were forecasting earnings growth of 12 percent in 2004. But now it looks like we’ll do close to 20 percent, and we did 18 percent in 2003,” Cooper said. “We are actually growing at a faster rate than we did last year, and analysts have been behind the curve when it comes to earnings growth over the last year. So what’s to say they are not still behind the curve?”

Ned Riley, chief investment strategist at State Street Global Advisors, doesn’t think the rate of earnings gains seen in the first half of 2004 will be repeated in the second half. “And companies won’t be as giddy as they have been in the recent past with their outlooks for future quarters; I doubt they’ll give guidance beyond (one) quarter,” he said.

Still, Riley thinks the stock market may rally at some point in the next two months.

“It’s more of a function of a lessening of the factors weighing on the market,” said Riley. “It’s a contrarian view: Investors are not factoring in rates rising modestly, nor are they factoring in a lessening of the violence in Iraq or an easing of the troubles getting oil shipments out of Iraq. And so if those things come to pass it might give the stock market a boost.”