Earnings Data Will Challenge Stocks’ Strength

The U.S. stock market is about to face its toughest challenge yet this year: clear evidence of a slowdown in corporate earnings growth.

As major companies begin to report third-quarter results this week, fear is rising that disappointing earnings will be the trigger for a broad market selloff.

Indeed, with most investors sitting on significant paper gains in stocks, earnings reports may provide as good an excuse as any to take some money off the table.

“We’re headed for some turbulence,� warns David Bostian, investment strategist at Herzog Heine Geduld in New York. “That’s a nicer way of saying we’re in for a [market] decline.�

Last Friday brought fresh reminders that earnings at many U.S. companies are under pressure, after two years of stellar increases.

DSC Communications, a telecommunications equipment manufacturer whose earnings have been surging since 1992, warned that its third quarter results won’t meet analysts’ expectations because of slower orders from phone companies.

DSC’s stock promptly plunged $8 to $44.375 in very heavy trading.

Orbit Semiconductor, a supplier of specialty computer chips, also issued a downbeat earnings forecast Friday, and its shares plummeted $6.50 to $9. Not too long ago Orbit was a $27 stock.

And after the market closed, two very well-known software firms--Novell and BMC Software--added to the growing chorus of companies projecting lower quarterly results.

Every business has its own particular troubles, but most earnings shortfalls can be traced to the same basic problem: slower-than-expected sales.

What appears to be happening is that the U.S. economy’s deceleration this year is finally being reflected on corporate income statements. One can argue that that shouldn’t exactly be a surprise, but some Wall Street pros believe that many investors are clinging to the belief that the weaker economy is “someone else’s problem.�

“People are just beginning to realize that the profit cycle is slowing,� says Richard Bernstein, who monitors earnings at Merrill Lynch & Co. in New York. “But they’re still saying, ‘Not my stock.’ It’s a form of denial.�

Of course, many companies undoubtedly will report profit growth that meets or exceeds investor expectations. Aluminum giant Alcoa did so on Friday, when it said third quarter earnings soared 225% from a year ago, to $1.27 a share, as demand remained strong while production costs fell.

Earnings-tracker Zacks Investment Research in Chicago says Wall Street analysts’ estimates of third quarter results for the Standard & Poor’s 500 list of blue-chip companies add up to a tidy 17% average gain over year-ago results.

Among the industry groups expected to post the biggest gains are airlines, semiconductor makers, chemical companies and computer software firms.

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But as Friday’s warnings from Novell, Orbit Semiconductor and BMC Software demonstrate, optimistic estimates are like targets waiting to be shot down--especially in an economy whose growth is sluggish at best.

What’s more, with stock prices overall still near record highs, there is a strong chance that investors will increasingly take the view that even better-than-expected third quarter earnings are already built into share values.

In other words, the risk is that stocks will get no great additional lift from handsome earnings gains, as they did in the first half of this year.

Alcoa’s stock performance Friday didn’t provide much solace for market bulls. The share price soared from $51.625 to $54.75 after the company’s earnings were announced. But as trading wore on the stock fell back, closing at $53.125, up $1.50 for the day.

Nor has semiconductor company Micron Technology’s stock been able to sustain its momentum, despite a robust earnings report issued Sept. 21 for the quarter ended Aug. 31. Micron’s shares fell $3.875 to $70.725 on Friday and now are down 25% from their 1995 peak of $94.75.

David Shulman, investment strategist at Salomon Bros. in New York, argues that investors’ problem isn’t with third quarter earnings, but with what those results say about the future.

If people believe that earnings gains will continue to slow from their dramatic pace of the past two years, there will be little or no incentive to bid stocks higher, he contends.

Instead, with blue-chip stocks already priced at 15 to 16 times this year’s estimated earnings per share, on average--a level that often signals a market peak when the earnings outlook is fading--the more likely path for share prices is down, Shulman says.

In recent weeks, however, rather than run from the market as a whole, some investors have opted to run into stocks whose earnings growth in the near future is expected to be fairly reliable, albeit not as exciting as what technology companies may produce.

Hence, shares of drug, food, tobacco and other consumer products companies have been soaring even as investors have clipped the stocks of many technology and industrial firms.

Procter & Gamble shares, for example, hit a record $80.125 on Friday, up $1.125 for the day. Johnson & Johnson also hit a record, up $1.75 to $77.25.

“People are desperate to find steady earnings growth,� says James Engle, chief investment officer at Wood, Struthers & Winthrop in New York.

While that herd move into so-called defensive stocks is logical in a time of earnings jitters, the worrisome image is one of musical chairs: Investors are increasingly finding fewer and fewer companies that can satisfy the need for a high visibility of earnings growth ahead.

“The market’s first reaction is to rotate� into defensive issues, says Ben Zacks of Zacks Investment Research. “But at some point even those stocks will get to a level where people will say, ‘It’s safe, but is it worth 22 times earnings?’ �

The key question is whether bears like Shulman are correct in assuming that corporate earnings growth will continue to slow well into 1996--or worse, that a large number of companies will begin to report year-over-year profit declines.

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If the global economy’s pace picks up in 1996, the bulls can make a powerful case that earnings growth will revive as well, enough to fuel a fresh advance in stock prices after whatever short-term pullback, or “correction,� might ensue in coming weeks.

It’s also worth remembering that the market may have one very important ace in the hole: The Federal Reserve Board may decide to lower short-term interest rates again this fall, perhaps as early as mid-November.

The Fed’s move could be prompted by fears that the economy isn’t snapping back quickly enough from its spring and summer slowdown, and/or by a desire to reward Congress and the Clinton Administration if a long-term plan to balance the federal budget can be worked out.

“I think the economic situation warrants aggressive Fed easing,� says Herzog Heine’s Bostian.

If he’s right, it may only be a matter of time before the stock market regains its footing. How much damage will be inflicted between now and then, however--courtesy of weaker-than-expected third quarter corporate earnings--is the question many on Wall Street are afraid to ponder.

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Wall Street Still Expects a Lot

Compared to a year ago, third-quarter corporate earnings should be strongest for cyclical industrial companies and technology firms, according to analysts’ estimates. But because those estimates are most vulnerable to negative surprises, investors increasingly have been flocking to stocks of companies whose earnings growth is slower but more reliable--such as food producers, banks and tobacco companies.

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Industy Estimated gain/decline in third-quarter earnings* Aluminum +311% Airlines +71% Semiconductors +48% Chemicals +41% Computer software +34% Medical supplies +26% Engineering +20% Int’l oils +18% Tobacco +15% Soft drinks +14% Toy makers +14% Foods +7% Regional Banks +7% Home Builders -9% Clothing retailers -15% Truckers -33% Auto makers -52%

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* Compared to third-quarter 1994 results.

Sources: I/B/E/S; Prudential Securities