Positive Profit Surprises Now Widely Expected


Mixed economic data has triggered some choppy trading, but the major indexes have avoided a substantial correction. The Dow Industrials and S&P 500 Index are trading within 2% of the 2009 highs reached on Sept. 22, while the Dow Transports are less than 6% below their Sept. 15 high.

Near-term trading will hinge on economic data and news on September-quarter results. With stocks and profit expectations up sharply over the past seven months, investors will be looking for concrete signs that the business outlook is improving — and that lofty expectations for 2010 profit growth are realistic.

While most on Wall Street seem to expect any market pullback to be shallow, we think a material disappointment impacting the outlook for 2010 could trigger a substantial correction. For now, our equity portfolios hold 25% to 30% positions in Vanguard Short-Term Investment-Grade ($10.54; VFSTX) as a hedge.

Expectations and valuations

Consensus estimates project a 25% year-to-year decline in per-share profits for the S&P 500 Index for the September quarter. Among the S&P 500’s 10 sectors, only consumer discretionary and financials — both of which reported horrendous results in the year-earlier quarter — are expected to report gains.

Profits are widely expected to exceed consensus forecasts. First, expectations for third-quarter earnings have retreated since the quarter began, even though expectations for U.S. and global economic growth for the quarter have improved. Also, companies have learned to manage Wall Street expectations, with the percentage of S&P 500 members exceeding consensus profit estimates reaching 73% in the June quarter.

As always, however, the share-price reaction to quarterly results will show whether results have met expectations. That seems especially true for the September quarter, when the biggest questions will center on the outlook for 2010.

Profit estimates for 2010, on the rise since May, now call for a 27% profit gain for the S&P 500 Index. All 10 sectors are expected to deliver profit gains, with gains exceeding 20% forecast for the economically sensitive consumer-discretionary, energy, financials, materials, and technology sectors. Based on expected year-ahead profits, the price/earnings ratio for the S&P 500 Index is nearly 15, close to a two-year high and up from about nine in October.


With stock valuations and expectations for 2010 up sharply, better-than-consensus profits will not be enough to sustain the market’s advance. Without concrete signs that expectations for 2010 are realistic, a pullback seems likely.

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