Robust Profit Growth Seen in 4th Quarter

Corporate America is poised to report its seventh straight quarter of profit growth, and perhaps the biggest year-over-year gain in earnings in nearly four years.

But Wall Street’s glee about fourth-quarter results is tempered somewhat by fears that earnings growth is peaking. Although it wasn’t obvious then, the beginning of the 2000-02 bear market coincided with the zenith of profit growth in the first quarter of 2000.

This time around, many market pros don’t believe share prices are about to hit a wall. Still, they concede that the expected deceleration in the pace of profit growth in 2004 is likely to make investors more discerning about the stocks they buy.

Fourth-quarter results, which companies will begin reporting in about three weeks, are on track to be robust. Operating earnings (results before one-time gains or losses) of the blue-chip Standard & Poor’s 500 companies are expected to jump 21.9% from a year earlier, based on analysts’ estimates as tracked by research firm Thomson First Call in Boston.

That would be the biggest gain since earnings were up 23.6% in the first quarter of 2000.

Profits have soared in the second half of this year as the economy has recovered sharply from the slowdown induced in the first half by the war in Iraq. Layoffs and other cost cutting in 2001 and 2002 have afforded many companies enormous leverage: Any rise in revenue can go directly to the bottom line.

The earnings rebound has underpinned the stock market’s surge this year. The Dow Jones industrial average ended Friday at 10,278.22, a 19-month high. It’s up 23.2% year-to-date.

But Wall Street is supposed to look ahead, not behind. And analysts are projecting much slower S&P; 500 earnings growth in the first half of 2004 -- about 13%, year-over-year, in both the first and second quarter, according to Thomson First Call.

In part, the percentage gain in earnings is expected to slow next year as each quarter’s results compare with this year’s improved numbers.

Abby J. Cohen, market strategist at brokerage Goldman Sachs & Co. in New York, says it’s a myth that bull markets always top out with peaks in profit growth. Stocks could continue to rally even if earnings advanced at a slower pace, she said.

“The history of most market cycles suggests that share prices continue to rise when profit growth is moderate and accompanied by moderate inflation,” Cohen said.

Other experts say analysts could be too conservative in their profit estimates for 2004, which was true for most of this year. That could mean pleasant surprises for earnings -- and stocks -- next year.

John Snider, co-manager of the TCW Galileo Large Cap Value stock mutual fund in Los Angeles, is among those who believe analysts may be erring on the low side in their estimates, as they did coming out the early-1990s recession. That makes it more likely that stocks aren’t overvalued and that bargains can be found, he said.

“In 1992-94, the earnings improvement generally outpaced the consensus, and I think that can continue in 2004,” Snider said.

Many investment pros say the market’s trend of recent weeks suggests investors are following the usual pattern at this point in the economic cycle: They’re looking for companies whose profit growth is expected to accelerate fastest in the next year.

Snider, for one, sees value in industrial and commodity companies that benefit when the economy gets rolling.

The basic-materials sector of the S&P; 500 -- producers of paper, chemicals and metals, for example -- is expected to post a 49% gain in earnings growth in 2004, up from 11% this year, according to Thomson First Call data.

Stocks in that sector include nickel mining firm Inco Ltd., which hit a 52-week high of $38.11 on Friday in New York Stock Exchange trading. The stock is up 80% this year. Inco’s profit is expected to rocket almost sixfold, from 48 cents a share this year to $2.85 in 2004.

Many transportation companies also are expected to show strong results next year. The Dow transports stock index on Friday reached its highest level since March 2002.

In the technology sector of the S&P; 500, overall earnings growth is expected to decline next year from this year, but that reflects big turnarounds in 2003 for a handful of companies. The tech sector still is expected to report a hefty 33% jump in profit next year.

The growth picture is less clear for some other industries, such as housing.

Mortgage lender Washington Mutual Inc. warned Dec. 8 that its 2003 earnings would be below expectations because of a fourth-quarter shortfall, as lending slows. The news hammered the stock and made more investors nervous about the housing sector in general. Home builders’ stocks, among the market’s biggest winners this year, mostly have pulled back from their recent peaks.

“It’s not surprising to see an industry group lead for three, six or nine months and then fade from popularity as we get earnings deceleration,” said John Bollinger, president of Bollinger Capital Management in Manhattan Beach. “We’re at very high valuation levels. That means everything has to come out just right, and every disappointment will be punished severely.”

Suppliers of telecommunications equipment also have lost some of their luster in recent weeks on earnings jitters.

Scientific-Atlanta Inc., for example, closed Friday at $26.64, down 28% from its 2003 high of $37.02 reached in September. Fiber optic gear maker Corning Inc. has tripled year-to-date, but at Friday’s close of $10.43 it’s off 13% from this year’s peak of $12.01 reached in early November.

“The telecom companies got a big boost this year when people were playing the [economic] rebound, but now some of the reality is setting in,” said Chris Orndorff, head of equities at Los Angeles-based money manager Payden & Rygel. “The pickup in capital spending will help, but maybe not to the degree people were counting on.”

The S&P; sector that is expected to post the biggest drop in earnings next year is energy. Yet in recent weeks many energy stocks have zoomed as oil and natural gas prices have risen anew. The performance of the energy stocks may reflect that investors believe analysts are too pessimistic about next year’s profits, some experts say.