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A fourth-quarter earnings surprise? Don't bet on it
Some believe the economy -- and corporate profits -- will soar in the fourth quarter, pushing up stocks more. But that theory is based on plenty of assumptions.
By Jim Jubak
So how do you justify believing that stocks will keep moving up from here?
Here are three theories:
First, while stocks are now fairly valued, trends always run to extremes, and we can count on investors becoming irrationally exuberant again and bidding up stocks to silly prices. Just sell to the greater fool.
Second, historically low interest rates justify much higher price-to-earnings ratios on stocks. With the federal funds rate at 1.25% and possibly heading lower, price-to-earnings ratios should be around 30 instead of their current 18 times projected earnings. So stocks are about 40% undervalued. The experts are locked in bitter debate about whether this so-called Fed model really works when interest rates get very, very low. After all, following this logic, shouldnt Japanese stocks be soaring since interest rates there are near zero?
Third, stocks will go higher because fourth-quarter earnings will come in much, much higher than projected.
A fourth-quarter earnings surprise is possible, according to investors who believe in this scenario, because the economy will grow much more strongly than anyone expects in the December quarter.
The consensus estimates
Now, the consensus among economists is that economic growth will accelerate to 3.7% in the fourth quarter, up smartly from a projected 2.1% in the second quarter that ends in a few weeks and up slightly from 3.5% in the third quarter.
But that fourth-quarter figure is far too low, the fourth-quarter surprise scenario says. Look at everything thats lined up to push growth higher, its supporters say.- Already low interest rates will fall when the Federal Reserve cuts rates on June 25.
- The $350 billion, 10-year tax package will start putting money in consumers pockets in July.
- A weaker dollar will make U.S. goods more competitive overseas.
- Tax breaks in the new law make it even cheaper for companies to buy new capital equipment, at least through 2004.
- The fourth quarter is historically by far the strongest quarter for technology sales.
All this could push economic growth in the fourth quarter to 6% rather than the 3.7% projected, which would result in a tremendous rally in stocks.
Could that happen?
Rare but not unknown
Its certainly possible. Six percent economic growth is rare but not unknown. The economy grew 5.2% 1999's third quarter and 7.2% in that year's fourth quarter, just before the bubble burst.
And historically, an economy bouncing back from the typical recession is perfectly capable of this kind of growth. The 1957-1958 recession, for example, led to back-to-back quarters of 9.3% growth in 1958. More recently, the 1980 downturn was followed by quarters of 7.3% and 8% growth.
This kind of explosive growth produces an even bigger increase in corporate profits. Companies have cut costs to the bone during the slowdown, so any pickup in sales sends a cascade of profits to the bottom line.
At least thats the theory.
In reality, not every economic slowdown is followed by a massive burst of growth.
The 1990-1991 recession produced three quarters of contraction: The economy shrank by 0.7% in the 1990 third quarter, by 3.2% in the fourth quarter and by another 2% in 1991's first quarter.
A weak bounce back
But the rebound was anemic. The economy grew by just 2.3% in the 1991 second quarter and then by 1.1% and 2.2%, respectively, in the next two quarters. Earnings on the S&P 500 stocks climbed just 0.4% in the first quarter of that weak rebound, 6.7% in the second quarter, and then actually dropped 9.2% in the next quarter.
So which will it be? The strong economic recovery of late 1980 and early 1981 or the weak economic recovery of 1991?
At this point in the cycle, investors dont know the answer. Yes, all the available fiscal and monetary forces have been deployed to restore growth. But so far theres no concrete evidence that theyre working. Manufacturing activity was up in May compared with April, according to the Institute of Supply Management. But manufacturing activity still contracted during the month, just at a slower rate.
The fourth-quarter earnings surprise at this point remains a hope, just like the more restrained forecast of any economic recovery at all in the second half. And until companies start to say positive things about the third quarter, it seems early to bet on the fourth.
Editor's Note: A new Jubaks Journal is posted every Tuesday, Wednesday and Friday. The Wednesday edition stems from Jim's appearance on CNBCs Business Center most Wednesday nights at approximately 5:45 p.m. ET. Selected CNBC stories can be found in the TV Reports index.
At the time of publication, Jim Jubak didnt own or control shares in any of the equities mentioned in this column. He does not own short positions in any stock mentioned in this column.
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