Wall Street Earnings Estimates Are 'The Worst'
By Brady Willett

The Fed will leave interest rates alone this week but they will likely tweak their bias (or statement) to reflect a more optimistic economic outlook. Even though a bias switch back to neutral is generally regarded as a 'good thing', there are potential pitfalls to consider.  Specifically, the FOMC statement may serve as the second warning that the Fed is preparing to raise interest rates. The first warning that rates are headed higher came when the bond market got hammered over the last two weeks.

Side Note: With this in mind, and given that there is no inflation to speak of, CNBC's Larry Kudlow is probably preparing to repeat what he has said many times before, or that the Fed is getting ready to 'punish economic success'. 

The three to five paragraph statement from the Fed is regarded as the most important event this week.  However, earnings pre-announcements could steal the spotlight.

Don't Look Directly At Corporate Earnings – You May Burn Your Eyes
 Like a card-mechanic using sleight of hand to fool the audience, under the tutelage of Wall Street investors have been coaxed into looking away from corporate earnings for the last six months – they have been directed to look solely at the prospects of an 'economic recovery'. By ignoring corporate earnings the markets, in large part, were able to 'bottom' in September based upon the 'worst is over' logic. That this logic seems to be proving prescient now has simply added fuel to the rallying fires.

However, with the economic rebound supposedly already at hand, it is not a stretch to assume that investors will uncloak their eyes and begin fixating upon corporate earnings.  With this in mind, so long as the magic stock market show can distract enough attention away from dismal 1Q02 earnings results, there is hope. 

Hope: To wish for something with expectation of its fulfillment

When it comes to the economy, the fulfillment of 'the worst if over' adage was easy – so long as the economy didn't blow up success would be achieved.  That said, remember that the economy is not necessarily 'strong' or even 'stable' – rather, it is only perceived as being both of these things when compared to yesterday's weakness (recession)…

By contrast, fulfilling earnings expectations may prove to be a considerably more difficult trick.

 Is The Earnings Rebound About To Begin?
The carnage in profits is expected to end this quarter and the ramp up in earnings expectations for the remaining 3 quarters this year are very optimistic:

1Q02

-8.6%

2Q02

+9.0%

3Q02

+30.9%

4Q02

+41.7%

First Call

Yr/Yr Gain

Understandably, 4Q02 numbers are compared to the weak 4Q01 date this will make it easier for companies to improve their bottom lines.  Even so, a case could be made that Wall Street is expecting perfection.

Are The Estimates Objective?
Many analysts have either learned or have been told to never rate companies a 'sell', never to say that things look 'bad' without presaging such a statement with 'longer term things always look good', and never provide objecte corporate earnings estimates.  Granted, the word 'objective' is somewhat vague, but consider this: the leading independent monitor of corporate estimates, First Call, states that, "industry analysts currently expect earnings will be up 17.0% in CY02. We believe the more likely outcome would be a lesser gain, probably closer to 5%."  Chuck Hill, from First Call, doesn't rate stocks buy or hold and he doesn't rely on corporate America to pay his bills.  Rather, he can be said to look at corporate earnings 'objectively'.

A Repeat of 2001?
 On April 1, 2001 analysts expected 4Q01 earnings to be up 12.6%. Instead, earnings arrived at negative 21%.  Admittedly, no one could have predicted September 11.  Nevertheless, it should also be noted that due to 9-11 companies dumped every scrap of negative news possible into their 3Q01 numbers not their 4Q01's.  Moreover, GDP growth was actually up by 1.4% in 4Q01 – the economic rebound occurred quickly while earnings did not.

It should also be remembered that Wall Street was slashing estimates well before 9-11 ever occurred: as stated, on April 1 they expected 4Q01 EPS to come in at +12%, but by September 1 these estimates had fallen to –12%.  As such, and to borrow some Ralph Acampora wisdom, lets just say that 4Q02 earnings will either by up, or down by 50%. This is as about as accurate as Wall Street is when looking beyond next week.

The Forgotten Wild Card
Almost no major media outlet picked it up, and Wall Street didn't flinch when Greenspan announced that 'stock options should be expensed on books' during his testimony two weeks ago.  At first, some may say this is great news – transparency for investors!  However, if stock options are expensed you can kiss any earnings rally good-bye.  Let me rephrase that, you can try to kiss the earnings rally good-bye – but by the time you pucker up many tech stocks will be down 10-20%, and this is the conservative estimate. 

Expensing stock options is only the tip of the iceberg.  What Enron has done is raise a red flag signaling that corporate America cannot be trusted and that new accounting laws are needed.  However, the likelihood of new and damaging (to near term EPS) laws coming to pass this year is unlikely.  Why?  Because while the rhetoric from Bush, Pitt, Greenspan, and O'Neil surrounding Enron has been fierce, corporate America is funding a massive assault to stop new regulatory efforts from developing. 

As the battle between corporate American and the regulators ensues, Wall Street has almost completely ignored the possibility of new regulations crippling corporate earnings.  And to think, just yesterday pro forma, off balance sheet debts, and barter revenues were not frowned upon either…

'Double-Dip' Disappointment?
A 40+% gain 4Q02 earnings may not be what this economy has to offer.  For starters, in order for companies to increase profitability margins will have to widen – price cuts and pricing incentives will have to be steadily reversed. Moreover, in order to acquire stable profits, not just a rebound in 2Q02 and a drop in 3Q02, the replenishment of inventories will have to be more than a temporary phenomenon. Lets face it, inventories may be posting small increases now (Jan) because companies miscalculated the ability of the U.S. consumer to spend following 9-11, not necessarily because corporate America is cranking up production to explicitly meet sustainable demand.  Moreover, when considering that capital spending and corporate pricing power remains weak the much talked about 'double-dip' scenario appears even more plausible: will consumers (hampered by even more debt than when the recession began) continue to deplete inventories once corporate America raises prices? As question not easily answered.


The fact is that the consumer has made many purchases at the expense of corporate profitability and their savings.  As such, if consumers are required to carry the economic load while corporate America digs in for profits the outcome may be considerable less than 'perfect'. Furthermore, add to concern the inherent dangers of the Fed raising interest rates, which would immediately constrict the 'always' hot housing market, and it is not difficult to envision an economy left searching for another agent of growth.  Perhaps this is why Greenspan has recently been mentioning 'capital spending'.

Capital Spending Still In Recession
"We're out of the business of predicting when this economy is going to turn up in terms of capital spending,''
Oracle CEO Larry Ellison, Mar 14.

The reason why Mr. Oracle is done trying to predict when capital spending will increase, besides being wrong numerous times before, is because perhaps never before has the U.S. economy been in such an awkward position as today. To be sure, there remains a plethora of bad debts (particularly telecom) that need to be retired from the books, the Fed may soon signal that interest rates will soon be going up, corporate profitability is crawling out of the gutter, and capacity utilization is sitting at a 74.8%, or well below the 1967-2001 average of 81.9%.  



Perhaps the only assurances to be made is that capital spending increases profitability, and to be guaranteed of an uptick in capex price cuts and pricing incentives will have to steadily be reversed, and demand will have to be sustained. As Oracle and many other companies are finding out, this doesn't happen overnight.

Earnest Expectations
The conclusion to be made is that this year is turning out to be not that much different than last year - the markets are pricing in a significant earnings rebound late in the year.  However, while last year many investors had the courage to hold on for a little but longer, a similar scenario may not unfold this year if earnings expectations are not met. 

Although extremely isolated, we have already seen companies that disappoint (LU, ORCL, CMVT) see their share prices get decimated. This action (or the disappointment dump) is a clear-cut sign that optimism is dangerously ripe in many stocks and that this optimism (stock prices) can only be sustained by 'expected' or 'better than expected' financials.

It is worth remembering that during 3Q01 earnings season corporate America could have reported any numbers they wanted and the markets would have risen because 'the worst was over!'  By contrast, if Wall Street estimates for 2002 earnings are as far off the mark as they were at this time last year, investors may soon be finding out what 'the worst' really means.

Brady Willett
BWillett@fallstreet.com
www.wallstreetwishlist.com

March 19, 2002