The second-quarter earnings season was watched particularly closely as investors used the reports to understand how corporations from Intel (Nasdaq: INTC ) to Deere (NYSE: DE ) were wading through the recession. Investors had feared a problematic earnings season, but -- thanks mostly to cost-cutting initiatives -- three-quarters of companies beat earnings expectations, including Whole Foods, (Nasdaq: WFMI ) Visa (NYSE: V ) , and Alcoa (NYSE: AA ) .
But will earnings from the third quarter (which ends this month) be a roadblock? If companies don't show earnings growth attributable to revenue increases, will earnings beats attributable to cost-cutting again be enough to push stocks higher? More than that, when will earnings recover to surpass their prior peaks?
These are the questions I posed to the following five experts:
- Bob Doll, vice chairman and global chief investment officer of equities at BlackRock
- David Kelly, chief market strategist at JPMorgan Funds
- Uri Landesman, head of global growth at ING Investment Management
- John Linehan, co-director of T. Rowe Price's U.S. equity division and portfolio manager of the T. Rowe Price Value Fund
- Bernie Schaeffer, chairman & CEO of Schaeffer Investment Research
Here's an edited transcript of the experts' answers:
Regarding third-quarter earnings, if we're not seeing any top-line growth, how much cost-cutting can companies implement? Could corporate earnings be a roadblock for the market going forward?
David Kelly: I don't think so. If the economy grows, I think earnings will grow. It's very typical in the depths of a recession for companies to make all of their money through cost-cutting, because if the economy isn't growing, then revenues won't be growing.
At the trough of the recession, I would expect companies to be only able to show earnings through cost-cutting [rather] than through revenue growth. But if the economy does resume good economic growth of 3% or 4% over the next two quarters, I think there will be some top-line revenue growth.
I think analysts on Wall Street are also very nervous about being too optimistic here. If you look at the recent earnings season, even if companies beat expectations, analysts have been very slow to raise their expectations for the rest of the year. Thus I think we could see some surprises on the upside.
Bob Doll: They could. A lot of criticism about the earnings surprises in the second quarter was about cost-cutting. My terse response is go back and look at your history books -- that happens every recession. The first thing that happens is that businesses lay off workers and cut costs. You finally get a quarter or two [of recovery] because of the cost-cutting, and then it's eventually the top-line growth. But this isn't atypical in any way shape or form.
... Qualitatively, I think [third-quarter earnings] will be more of the same. That is, it will probably surprise a bit to the upside. A lot will be about cost-cutting. I think what we will need for the market to be OK is a little more evidence of top-line growth than we saw in the second quarter, and I suspect we'll get some of that.
Uri Landesman: I think there is probably still some cost-cutting left, depending on the industry, sector, or company. Clearly, you're going to need to start seeing some of it from the top line. Though companies have done a good job keeping expectations low enough for the third quarter that we probably have another quarter where there are more positive earnings surprises than negative. But as you say, the string is starting to get pulled pretty tightly. So there is certainly going to need to be some top-line growth looking out past that into 2010.
Bernie Schaeffer: Earnings are still in a position to surprise to the upside, as skeptics abound about cost-cutting being the major driver these days. Therefore, a return to top-line growth driven by a moderate recovery and easier comparisons would convince the naysayers that have earnings concerns.
When do you expect earnings to recover, and when do you expect earnings as a whole to surpass their prior peak?
Kelly: We're already seeing the earnings recovery. They've already turned the corner. The trough for U.S. corporate earnings was in the fourth quarter of 2008, where operating earnings were negative $0.09. They were then positive $10 in the first quarter, and about positive $14 in the second quarter. I expect they will continue to move up steadily -- though it's difficult to predict exactly -- roughly $15 in the third quarter, $16 in the fourth quarter and continuing to move up.
I think it will take us at least until 2011 to get back to the earnings numbers we saw in 2007. The economy needs to recover somewhat before we can get back to those levels we had two years ago, and we will need to see unemployment come down to achieve that.
As we come out of this, one of the advantages companies will have is in fact the high unemployment rate, because that's going to hold wage demand down. So any productivity gains that are achieved will probably go into boosting profit margins, rather than helping workers. So I think profit margins will actually do pretty well.
But there are risks, too. One of the risks involved in a strong recovery of profits is that if profits recover too fast, and workers get too squeezed, then consumer spending could stall out.
Then there's the federal budget. We've got massive budget debts projected out over the next decade. If profits come back in nicely, I don't trust Congress ... [not] to cook the golden egg and make an omelet out of U.S. corporate profits. We could see higher taxes on U.S. corporations, which could cause a problem.
Doll: It's going to be some time to come. It's going to take a while for us to restore it. Don't forget that it is going to take a long time to climb the hill after what we now know to have been a bubble in financial earnings. The financials will have to get back to their old earnings for the overall economy to get to its old earnings. But this is a several-year process to get there.
John Linehan: I think we should expect to see some earnings recovery next year. Clearly companies have cut and have addressed their cost structure. Even if we don't see a great deal of economic growth, you're going to see a reasonable increase in earnings just from the cost side. In terms of surpassing their prior peak, there's a chance we could get there 2011, possibly 2012, but I don't think it will be next year.
Landesman: I think they will recover gradually next year. ... The good news is that earnings were depressed for a while, so comps won't be that difficult. One of the good things about pulling out costs is that you have more operating leverage. So if you pulled your costs out, and you removed duplicative costs as opposed to growth-sensitive costs, then you've got a lot of upside when the top line returns.
So you could see some really nice stories as orders start to kick in. But, again, I'm still betting it will be gradual throughout the next year as opposed to off to the races in the first quarter next year.
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