Despite a stubbornly slow economic recovery at home and severe headwinds from Europe and Asia, U.S. companies are on track to deliver a tenth straight quarter of rising profits. But a closer look reveals some alarming trends.
With reports from more than 80% of the S&P 500 companies on the books, earnings are on pace to grow just 0.6% during the second quarter, the slowest since the third quarter of 2009, when companies were still struggling from the depths of the recession.
Though growth is lackluster, analysts are still willing to look beyond that, noting that 64% of the companies that have reported have topped Wall Street's expectations, which is higher than the average rate of 62% over the past decade.
But the sharp slowdown in revenue growth is less forgivable.
"Companies have been able to figure out how to manage earnings expectations, and from that standpoint, the quarter hasn't been terribly bad," said Wasif Latif, vice president of equity investments at USAA Investments. "But when you look at revenue, that's been disappointing."
Revenues are set to rise just 2.2% during the second quarter for the S&P 500 companies overall, down from growth of 6% during the first three months of the year. What's more, the decline came a bit as a surprise to Wall Street. About a month ago, analysts were expecting sales to grow about 5% for the quarter, according to S&P Capital IQ. As a result, only 41% of companies have exceeded revenue estimates, unusually low compared to the 10-year average of 61%.
"The slowdown in revenue is an indication of overall weakening demand and the economic environment," said Latif. "If top line sales aren't growing, that will put ultimately put pressure on profits."
And that seems to be the scenario that is beginning to unfold. Company executives have been extremely cautious in their outlooks, and analysts have ratcheted down their forecasts as well. In fact, over the past two weeks, estimates have gone from profit growth of 0.7% for the third quarter to a 1.4% decline.
Most CEOs are blaming Europe for the weakness.
For example, Apple's chief Tim Cook pointed to the continent's slowing economy as one of the factors contributing to the shortfall in iPhone sales. McDonald's (MCD) and Ford (F) also cited Europe as one of the areas where consumer confidence, and in turn spending, are falling.
CEO Scott Davis of shipping giant UPS (UPS) pointed fingers at Europe, as well as increasing uncertainty in the United States and ongoing weakness in Asia, as it lowered its outlook for the year. Chipmaker Advanced Micro Devices (AMD) also cut its outlook due to weaker-than-expected sales in China and Europe and overall sluggish demand from consumers.
As earnings expectations start to decline, company stock valuations are rising, noted USAA Investments' Latif.
The S&P 500 now trades at 13.2 2012 earnings estimates, up from a multiple of 12.8 just a month ago.
"When you reduce earnings estimates, valuations suddenly are less attractive," said Latif. "How much investors are willing to pay for those earnings is the ultimate litmus test for Wall Street."
That could spell trouble ahead. Bullish investors have been touting the relatively low valuations of stocks as a reason to keep buying. But as stocks creep higher, Latif said investors will have to be more careful to find companies that remain decent bargains.
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