A slew of weak earnings reports stoked fears that profits in the next few quarters will fail to hit lofty expectations, sending the Dow Jones Industrial Average down 2.64% Friday.
While investors have known for weeks that profits for the third quarter would suffer from turmoil in financial markets, many reassured themselves that a sharp turnaround would come in the current quarter, helped by a strong global economy.
Instead, many third-quarter results have fallen below even the diminished expectations, and pessimistic news from companies such as industrial bellwether Caterpillar Inc. suggested more unpleasant surprises to come. The heavy-equipment maker said it expects the U.S. economy next year to be "near to, or even in, recession," outweighing strong demand elsewhere around the world.
On the 20th anniversary of the 1987 market crash, the Dow Jones Industrial Average dropped 366.94 points to 13522.02, and other major indexes also fell more than 2.5%. U.S. Treasury bonds rallied sharply as investors fled to safety. The Dow is still up 8.5% for this year.
A succession of earnings surprises at banks revived fears that the worst of the credit crisis, which hit two months ago and seemed to ease, has yet to pass. The latest bad news came Friday from Wachovia Corp., the Charlotte, N.C., bank, which reported a 10% drop in net income after it recorded $1.3 billion in losses and write-downs related to credit-market turmoil. Wachovia also set aside money for rising delinquencies on everything from credit cards to home-equity loans.
"This is like July and August, part two," said Howard Simons, strategist at Chicago's Bianco Research. He was referring to the sharp decline in stocks in mid-August as concerns about shaky mortgage debts froze up credit markets. Stocks quickly recovered all their losses as investors believed the crisis had blown over.
Mr. Simons cited skepticism over a plan endorsed by several major banks aimed at rescuing the still-troubled market for short-term commercial paper. Instead of being reassured, he said, many see the plan as evidence the credit markets remain a mess.
Since the dot-com bubble popped and stocks hit a nadir in October 2002, strong profits have driven the market upward. In the past five years, earnings for companies in the Standard & Poor's 500 index have more than doubled, roughly paralleling the rise in stock prices.
U.S. companies still have some tail winds that could keep profits rising — most notably the weak dollar and strong growth in places like China, which boosts profits earned abroad.
But new factors threaten to overwhelm that advantage. The housing bust shows signs of spreading to distant industries. International Business Machines Corp. said its results were hit by problems in subprime loans to people with poor credit. That's because some of IBM's biggest customers are banks.
Crude-oil prices are up 45% this year, despite a slight dip Friday, and companies are having trouble passing on the higher costs to consumers. Meanwhile, slow growth in U.S. productivity is pushing up the cost of labor.
"The era of outsized profits is in the rearview mirror," said Raymond James chief investment strategist Jeff Saut.
Among companies in the S&P 500, net income for the third quarter is expected to fall 2.4%, says Howard Silverblatt, an S&P analyst. That would be the first drop since the final quarter of 2002 — ending the longest streak of profit gains since the late 1970s.
Beyond the third-quarter news, much of which was largely expected, the market is now being roiled by uncertainty about the next few quarters.
Analysts are looking for S&P 500 earnings growth of 10.4% in the fourth quarter, and 12.9% next year, according to Thomson Financial, whose roundup of analyst estimates discards some one-time charges. At the same time, they expect sales to grow by just 6.2% in the fourth quarter and 5.9% next year, according to Reuters Estimates. That implies companies will wring more profit out of each dollar of sales.
But improving profit margins is difficult when the economy is slowing, because companies' fixed costs can't be easily cut right away. It is especially difficult now with higher commodity prices. "A further increase in profit margins is hard to reconcile" with forecasts of slower growth, Goldman Sachs economists said in a recent report.
Earnings expectations appear particularly high for companies that have been posting the weakest results. Analysts expect consumer discretionary companies in the S&P 500 — a category that include retailers, home builders and restaurant companies — to earn 24% more next year than they did this year.
"Implicit in the estimates for next year is a stabilization of the housing market," says Sanford C. Bernstein strategist Vadim Zlotnikov. With the latest reports showing housing still on the way down, that suggests the profit forecasts must fall, he says.
The Federal Reserve's half-percentage-point interest-rate cut in September helped stabilize the bond and stock markets. But its impact is not likely to be felt in the broader economy for months, meaning it probably won't help earnings much in the next few months.
One company that has ratcheted down its fourth-quarter outlook is Eaton Corp., which reported third-quarter results Oct. 15. The Cleveland-based industrial conglomerate, which among other things makes electrical equipment used in housing, has been hit harder than expected by the housing slump, according to the company's chief executive, Alexander M. "Sandy" Cutler. The company is also being hurt by plunging sales of heavy trucks, which have been hurt by new emissions rules. Eaton is a major producer of truck transmissions.
Mr. Cutler says Eaton no longer expects the economy to strengthen in the fourth quarter. However, he also noted that he is not predicting a recession. "There won't be a decline — but rather just a flatter period of lower growth," he says.
For U.S. companies, labor costs are another head wind. During the profit boom that followed the 2001 recession, companies reaped the benefits of the technology investments they made in the 1990s and the cost-cutting they did during the downturn.
Nationwide, unit labor costs, a measure of the cost of labor per unit of output, fell in 2002 and barely rose in the next few years. But as growth in worker productivity has slowed, unit labor costs have been moving higher. In the second quarter, they were 4.9% higher from a year ago, the largest year-over-year increase since mid-2000.
With overseas economies booming and the dollar weak, commodity costs are rising for many companies. Crude oil futures breached $90 a barrel Friday, a record high in nominal terms, before falling back and ending the day 1% lower at $88.60 a barrel on the New York Mercantile Exchange.
Last week, Kimberly-Clark moved to raise U.S. tissue and diaper prices, citing rising pulp and paper costs. Rising oil and natural rubber costs are cutting into the profitability of tire makers, too.
Import costs are also rising, especially from China, where wages are going up and policy makers are adjusting the currency higher against the dollar.
The price of Chinese imports was 1.6% higher in September than it was a year ago, according to the Labor Department, whereas a year earlier it was down by 1%. Last month Coach Inc. chief operating officer Keith Monda said that as a result of rising labor costs, his company was looking to move some of its handbag production out of China.
—Jon E. Hilsenrath contributed to this article.
source: p.A1
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