Stock Watch


A Constructive Earnings Season

Jeffrey R. Kosnett

The parade of positive 2010 third-quarter financial reports should reassure you that the stock market won’t do anything scary as 2011 approaches.



During the six-week period in which virtually all of the most important companies in America issued third-quarter financial reports, the U.S. stock market essentially went nowhere.

But don’t blame the snooze on the earnings news. Stocks roared ahead in September in anticipation of solid earnings reports and upbeat forecasts for the future. That stocks held on to their hard-won gains in October and November suggests that investors looked favorably on the most recently concluded earnings season. And barring some out-of-the-blue shock (collapse of Ireland or, even worse, Spain?), momentum should carry through the end of the year and perhaps into early next year, too. Here’s some of the evidence:

Pleasant surprises. With earnings reports in from all 30 companies in the Dow Jones industrial average and more than 90% of the firms in Standard & Poor’s 500-stock index, positive surprises outnumbered disappointments by 3.6 to 1, according to Zacks Investment Research. If the ratio is greater than 3.0 to 1, it’s been a good earnings season. Also, the only group in which the volume of negative reports came close to matching the positive ones was the financial sector. And even in that area, other indicators -- such as net profit margins and total sector earnings -- were strong. Truly ugly news was scarce.

Our bellwethers did well. Kiplinger’s recently selected 12 companies whose results, we contend, offer special insight into both the economy and the outlook for future earnings (see our slide show of 12 earnings reports that always matter). Of these, ten beat the average analyst earnings estimate for the quarter, Schlumberger (symbol SLB) tied, and Disney (DIS) missed -- by 1 cent a share. And there were no red flags among the dozen companies. Meanwhile, six of the 12 stocks are up since the companies issued their reports.

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Consumers aren’t dead yet. Shopping and entertainment by themselves cannot reinvigorate the U.S. economy. But if Americans do spend money more liberally, they’ll help put to rest worries about a double-dip recession. Disney, which has interests in movies, ESPN, A&E and ABC, as well as theme parks and resorts, saw revenue rise in each of its business segments over the past year. And most retailers topped expectations for both sales and earnings.

No contagion. As always, some important companies rattled shareholders with unexpectedly poor results or dire warnings. But there’s no evidence that entire industries are backsliding. Cisco Systems (CSCO), the networking-equipment giant, reported decent numbers for the quarter that ended October 30. But it spiked its report with a downbeat forecast and the jarring revelation that sales to state and local governments -- big customers for Cisco -- plunged. Cisco’s shares sunk 16% that day and, at $19.56, have sunk another 4.7% since. But Cisco’s stinker didn’t rub off on the rest of the technology sector. The stocks of Apple (AAPL), Hewlett-Packard (HPQ), International Business Machines (IBM), Intel (INTC) and Microsoft (MSFT) have all basically held steady since just before Cisco’s spill. In fact, the tech-heavy Nasdaq Composite index has been the strongest of the broad blue-chip indexes since earnings season got under way.

It’s not all about cost-cutting. Putnam Investments market strategist Jeff Knight says he took comfort from the latest round of reports because “there was more balance between increasing revenues and cutting costs.” That’s encouraging because there’s a limit to how much companies can expand their profit margins by firing workers, cutting benefits and refinancing debt at lower interest rates. Business needs to sell more goods and services to ensure healthy, long-term profit growth. Figures from Zacks confirm Knight’s assessment. Six in ten companies exceeded analysts’ revenue forecasts.

Filling the news vacuum. One of the good things about earnings season is that it gives investors something tangible to focus on. In the absence of reports from important companies, investors will often hone in on issues that may -- or may not -- be terribly relevant to the health of corporate America and the stock market. For example, the market dropped 1.6% on November 16 on concerns about distress at Irish banks. Few major companies reported earnings that day. It’s not hard to imagine, though, that the news from Ireland might not have cut so deep had it had to share headlines with, say, blowout earnings and a dividend increase from a Procter & Gamble (PG) or a Johnson & Johnson (JNJ). The stock market’s rebound two days later coincided with major news: The completion of the initial stock offering of the new General Motors (GM). When we watch fourth-quarter earnings reports in January and February of 2011, we’ll add GM to our list of bellwethers.

SEE OUR SLIDE SHOW: EARNINGS REPORTS THAT ALWAYS MATTER



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