News Analysis date published New: 
Wednesday, July 18, 2012 - 08:30
New Date created: 
Wednesday, July 18, 2012 - 14:28
New Date last updated: 
Wednesday, July 18, 2012 - 08:30

Why this Earnings Season Could Seriously Threaten Your Portfolio

Wednesday, July 18, 2012 8:30 AM

We can say this about Wall Street strategists: They are usually wrong before they are right.

Back in February, I noted that many of the top market forecasters were calling for a challenging market.

Many of them thought the S&P 500 would finish the year at around 1,350 or lower, but that happened to correspond with where the market was trading at the time. It turned out they were out of touch, as the market rallied nicely.

These days, that dim view for the broader market is looking a lot more perceptive.

At this point, there are enough headwinds in place to make you wonder whether we've seen the highs for the year. Of course, the market has been able to power past economic headwinds before (most notably in the fall of 2010 and the fall of 2011) so it's too soon to write the market off completely.

Of course, we'll get a fresh read on the market's direction as companies weigh in with second-quarter results. As I've noted before, results for the second quarter may be OK, but companies might start talking about how current economic conditions are making it a challenge to meet third-quarter forecasts. Analysts have been steadily lowering their profit assumptions for the third quarter, and we'll soon know if more cuts in these forecasts are necessary.

Analysts at Merrill Lynch are now noting concerns that investors should be fretting about the fourth quarter's profit levels. They have a hard time squaring the fact that while consensus forecasts for the S&P 500 call for earnings per share to rise 14% in the fourth quarter from a year earlier, they say the U.S. economy will have grown just 1% by then.

Merrill's key takeaway:

"Although the bottom-up consensus forecasts have continued to drift lower since last summer, they still appear too optimistic in light of the ongoing European crisis, the looming fiscal cliff and the slowdown in China. The recent weakness in earnings revision and guidance trends may be a sign that consensus expectations are in the early stages of being reset lower."

Merrill's strategists have an especially dim view for fourth-quarter profits among technology, energy, financial and industrial stocks, and expect consensus forecasts to come down in these four groups. These analysts now expect aggregated profits for the S&P to rise 4% in 2012 to about $102 and another 7% in 2013 to $109.

This means the S&P 500 is valued at around 12.2 times that 2013 forecast, which may seem a bit rich in the context of anemic profit-growth.

The pivot point
Here's what we don't know: At which point will investors stop feeling the heat of near-term profit pressures and start focusing on how cheap stocks are in the context of the economy and corporate profits in 2014 and 2015? History has shown that stocks begin to rally once investors start to look past a trough.

You could make a reasonable case that the global economy will constrain corporate profits for the next three to six quarters. But when the housing market gets back on its feet, when the European crisis has morphed into a series of permanent fixes, and when emerging economies like Brazil and China are back on a robust plane of growth, then U.S. GDP growth could move back toward 3-4% and S&P 500 profits could hit $120-125 per share.

How likely is such a scenario to play out in 2014? Time will tell, but it may be unwise for long-term investors to focus on a sober near-term outlook for the U.S. economy when its considerable strengths may finally take root by 2014.

Risks to Consider: Merrill Lynch's dim near-term view is likely to be echoed by other market watchers once second-quarter results have been digested, so get ready for a tough trading month.

Action to Take --> Once investors look past the present (and the mid-term), they are likely to take note of a reasonably valued market in the context of longer-term merits. This kind of long-term view is exactly why we stress the importance of "forever stocks" in our Top-10 Stocks newsletter. Because while the near-term macro picture might not look very promising, investors will likely do well as long as they focus on buying shares of solid, industry-dominating companies at reasonable prices.

Indeed, we may see a redux of 2011, when stocks slumped badly into August and then posted a solid rebound once the fourth quarter kicked in. By then, "investors were looking ahead," and though the 2013 outlook will likely be challenging, expect to hear more chatter about a 2014 renaissance.

David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.