Profit pressures could stall stock market rally

NEW YORK - The stock market thinks the economic recovery is under way. It had better be right.

The historic market rally since March lows has returned $2 trillion to battered household savings accounts and prompted once-skittish investors to dip back into stocks. Much of that rally has been based on the belief that early signs of an economic recovery will soon translate into a pickup in corporate profits. 

Investors have high hopes for those profits kicking in. By one measure, they’re paying more than three times as much for stocks than they did at height of the Internet bubble in 2001.

Now, as companies begin reporting their results for the third quarter, investors will get a chance to see whether the recovery is really happening. Even if it is, it's less clear whether it can be sustained.

Since the recession began in Dec. 2007, corporate profits have fallen off a cliff. Total earnings per share for the companies in the S&P 500 index fell from $734 billion in 2007, to $423 billion last year.

Thanks to historic cost-cutting — as companies sharply scaled back staffing and cut inventories to the bone — Wall Street is looking for profits to bump up to $483 billion this year, and then post a strong rebound to $651 billion next year.

Expectations of that rebound have driven the stock market up 54 percent since March.

But raising profits by cutting costs can’t go on forever. There’s little indication that overall demand is picking up. The forecast is for third quarter sales to extend a 9-month streak of double digit declines, according to Howard Rosenblatt, an analyst who tracks earnings for Standard & Poor’s.

“You cannot grow that bottom line until you grow the top line,” he said. “Overall, companies so far have not increased their sales at all.”

Companies with overseas operations have fared somewhat better. One major support for profits is coming from the weak dollar, which helps boost U.S. exports and amplifies profits made from overseas operations.  Profits should also hold up relatively well for companies operating in regions of the world with stronger economies.

For example, restaurant operator Yum Brands Inc., whose brands include Taco Bell, KFC and Pizza Hut, on Wednesday reporter an 18 percent increase in third-quarter profits. Much of that was from robust sales in China.

But the overall drop in U.S. corporate sales — over $1 trillion in the 12 months ended in June — is the result of a sharp pullback by consumers. With unemployment rates expected to hit 10 percent next year, and remain stubbornly high for years, corporate America may have a hard time expanding overall demand.

“We saw our jobs report — in September and in revisions for August and July — both down again,” said investment advisor Drew Kanaly. “We're still destroying jobs. So growth domestically still has a huge headwind.”

Investors have taken a more optimistic view in the past sixth months, paying higher prices for stocks on the belief that profits are headed up. As of the second quarter, the price to earnings ratio for the S&P 500, a measure of how "pricey" stocks are, topped 140 — up from 25 a year earlier. That ratio hit 46 at the peak of the Internet bubble. (A second measure, based on company's operating profits — which ignores one-time gains and losses — shows a more modest ratio of 27. That's up from 18 a year ago and just shy of the peak of 29 at the height of the Internet bubble.)

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That’s why Wall Street will be focused heavily on not just the results for the latest quarter, but the outlook for the coming year. So far, caution is a common theme.

Last week, the CEO of retail giant Wal-Mart warned that any pickup in sales would be sluggish.

“I think this recovery is going to be a slow one," Robson Walton told a global CEO business conference Kuala Lumpur, Malaysia.

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