Profit Warnings Pressure Stocks


Roughly every three months we tell subscribers that the coming earnings-reporting season will be crucial, and not once has our forecast been wrong.

Whether quarterly results trigger big share-price actions or not, they help reveal investors' expectations for corporate performance. Gauging where that bar is set will be especially important over the next several weeks, as September-quarter earnings are widely expected to be poor. According to Thomson Reuters, consensus estimates project a 2.8% year-to-year decline for S&P 500 Index earnings, the first drop since 2009.

While expectations for the September quarter have been falling since January — and some had argued that sentiment regarding the results was already about as downbeat as it was likely to get — companies warning on profits continue to see big share-price declines. Also, consensus estimates still project sharp rebounds in profit growth for the December quarter and full-year 2013, so the guidance provided with results has the potential to disappoint.

Are investors really expecting S&P 500 profits to be up 9.9% for the December quarter and 11.9% for full-year 2013? Common sense suggests they are not, as no major region of the world is expected to see accelerating economic growth in 2013. In fact, the International Monetary Fund recently lowered its forecast for global growth, predicting the world economy will expand 3.3% this year and 3.6% in 2013 — down from 3.8% in 2011 and 5.1% in 2010. For the U.S., the IMF expects about 2% growth for both 2012 and 2013.

If the September quarter truly represents the trough of this earnings cycle, history suggests that cyclical sectors like consumer discretionary, financials, and industrials will outperform over the next year. But if company guidance suggests profit comparisons are likely to get worse, such defensive sectors as consumer staples and health care are likely to do best.

Watch the averages

As always, investors should watch how the averages respond to earnings news. The Dow Transports have bounced since early October but are within 3.2% of the June low of 4,847.73. A close below that level, though discouraging, would not represent a bear-market signal under the Dow Theory unless confirmed by a close below 12,101.46 in the Dow Industrials. With a close above 5,368.93 in the Transports, the bullish primary trend would be reconfirmed.

For now, we are sticking with our wait-and-see posture, maintaining 10% to 15% of equity portfolios in a short-term bond fund as a partial hedge. For new buying, Express Scripts ($63; ESRX) is a top pick.

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