Can stocks continue to rise as earnings fall?

Associated Press Published: October 7, 2012
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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 3½-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.