Can stocks continue to rise as earnings fall?

[October 08, 2012]  NEW YORK (AP) -- One type of investor buys stocks when everyone is convinced that corporate earnings will fall. He buys because he thinks they're wrong and earnings will rise instead. Call him the contrarian.

Another type of investor buys when everyone thinks that earnings will rise. He buys because he thinks they'll rise even more than expected. Call him the eternal optimist.

Now, the 3 1/2-year-old bull market may have produced a third type of investor, an undiscovered breed with a curious strategy for success: He expects earnings to fall but buys anyway because he hopes it won't matter.

Call him the blind-faith investor. Or maybe just blind.

"How do you explain where the stock market is?" Barclays Capital stock strategist Barry Knapp said Thursday, as the Standard & Poor's 500 inched higher yet again. "Stock prices are not warranted by the fundamentals."

The financial reporting season begins Tuesday, when Alcoa announces third-quarter results. Brace yourself: For three months, stock prices have risen while, in seeming contradiction, Wall Street analysts have slashed estimates for earnings.

Earnings for July through September are expected to drop 1.3 percent compared with a year earlier for S&P 500 companies, according to S&P Capital IQ, a research firm.

That would break an 11-quarter streak of rising earnings that began just after the Great Recession ended three and a half years ago. Earlier this year, analysts had expected earnings for the quarter to rise 7 percent.

To be fair to the bulls, it's generally future quarters that investors should be most concerned about, not the one that just passed. That's a time-honored rule of investing.

But analysts have been cutting estimates for those quarters, too. They've lowered forecasts for earnings growth for each of the next two quarters by a third since the summer, and as much as half since the beginning of the year.

The bad news started in July, when UPS, the world's largest package delivery company, said the global economy was slowing and lowered its 2012 profit forecast as a result.

Then FedEx said that shipping volume had fallen to recession levels, and that investors should expect lower earnings. Norfolk Southern, the giant railroad company, cut its forecast, too.

The flurry of so-called negative pre-announcements ranged across industries -- from steel maker Nucor Corp. and Applied Materials Inc., which sells semiconductor-chip-making machines, to Starbucks and Tiffany & Co.

On Tuesday, Fifth & Pacific, the company behind Juicy Couture products, said sales were weakening and it was likely to report lower earnings than expected, too. Investors pushed its stock down 11 percent in just a day.

Tally it up and 78 percent of companies issuing pre-announcements have suggested they will disappoint, according to FactSet, a financial data provider. That is the worst reading since FactSet began keeping records six years ago.

The problem is companies are running out of ways to increase earnings. You can see that in the results for the previous quarter, from April through June. Earnings for companies in the S&P 500 barely rose from a year earlier, just 0.8 percent.

U.S. economic growth has slowed to an annual rate of 1.3 percent, practically stall speed. Meanwhile, the old formula that companies have used to compensate -- pulling more profit out of each sale by trying to run leaner -- suddenly isn't working.

You can only cut expenses and squeeze workers so much, and many companies seem to have reached the limit. Profit margins are falling for the first time in the recovery, after hitting a record of nearly 9 percent, according to Goldman Sachs.

The other way U.S. companies have posted higher profits is by selling more abroad. But many of the 17 countries that use the euro have fallen into recession. And developing countries are facing headwinds now, too. China, India and Brazil are slowing. On Wednesday, the Asian Development Bank slashed its growth forecast for emerging economies this year and next.

So what's kept stocks rising? One theory is loose monetary policy.

The Federal Reserve announced last month a third round of bond-buying to try to stimulate the economy. That followed a bold plan by the European Central Bank to buy government bonds of struggling countries in its region.

"Central banks have single-handedly kept asset prices elevated," said Peter Boockvar, equity strategist at trading firm Miller Tabak Advisors. "It's certainly not the economy. It's certainly not the trajectory of earnings."

To be sure, analysts have been too pessimistic before, and investors who ignored them made money. Analysts expected earnings to fall in the first quarter of 2012, but they didn't. Those who bought the S&P 500 at the start of the year are up 16 percent.

And even if analysts are right and earnings fall, you can still make money buying stocks, though history suggests it's risky.

In the 46 quarters since the start of 2001, earnings for the S&P 500 have fallen 15 times. Seven of those times, stock prices rose the following three months, sometimes spectacularly.

In the first quarter of 2009, S&P 500 earnings plunged 35 percent. Yet investors who were brave enough to buy stocks enjoyed an S&P 500 gain of 15 percent over the next three months. If they held on after that, they doubled their money.

Similarly, investors won big who bought after the third quarter of 2001, when earnings fell 23 percent. Stocks rose 10 percent the following three months. But unlike in 2009, the next few quarters produced losses as earnings kept plunging. Stocks dropped for the next three quarters, in one of them by 18 percent.

Investors shrugging off disappointing earnings now are hoping the current period resembles 2009. But it's not a sure bet, and they may end up getting something closer to 2001 instead.

[Associated Press; By BERNARD CONDON]

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