Big Earnings Gains May Not Lift Stocks

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Jim Young / Reuters / Corbis

Shoppers look through the aisles at a Toys "R" Us store in Falls Church, Va.

Stocks in the S&P 500 are expected to post impressive earnings gains in 2010, but experts caution that the gains may not be sufficient fuel for a continued stock-market rise.

Earnings gains may make for good financial headlines but they don't necessarily reflect the growth of the underlying business. Indeed, most companies have just wrapped up a year of dismal quarterly results where many slashed jobs and other expenses to weather the debilitating recession and frozen credit markets. Thus, the near-term earnings may look much improved even though demand for a company's products may have slumped. "Cost-cutting has been the major force driving earnings and earnings surprises," says Dirk Van Dijk, chief equity strategist at Zacks Investment Research, which monitors earnings projections from Wall Street analysts. And "clearly companies cannot continue to grow earnings forever based only on cost-cutting."

Van Dijk and other experts say investors should now pay special attention to top-line sales-revenue growth in addition to earnings for insight into a company's true business growth. Randy Cass, founder of First Coverage Inc., a financial-services-research company, agrees, noting that "2010 will be much more of a 'show me' type of year," in which investors demand clear data indicating that company fundamentals back up the run-up in stock prices seen in 2009.

Last year, investors were content to grasp onto any scrap of good news they heard during earnings conference calls as an excuse to buy up stocks even when top-line growth was soft, says Cass. "They were determined to find a silver lining in everything."

Not anymore. Earlier this week, aluminum giant Alcoa posted fourth-quarter results that fell short of Wall Street's expectations, triggering a sell-off in the company's shares. The company reported a loss of 28 cents a share, which was narrower than the $1.49-a-share loss a year earlier. However, it missed analysts' projections. Investors were particularly miffed at Alcoa's revenue number, which totaled $5.43 billion, down 4.6% from $5.69 billion a year ago. Analysts had been expecting revenue growth. Investors subsequently dumped shares, causing the stock to plunge 11%, its worst one-day drop since last March. "The reaction [to Alcoa's miss] is a reflection of what's to come," says Cass. "Welcome to 2010, where scrutiny and reckoning and ramifications are in vogue and giving people the benefit of the doubt is very last year."

Zack's consensus of analysts estimates is for a 27% earnings rise for S&P 500 stocks in 2010, but even if this is achieved companies will be earning 9% less in 2010 than they did in the peak 2007 period. Steven Wieting, a managing director and U.S. economist at Citigroup Global Markets, says it will likely be 2012 or 2013 before earnings reach the levels attained in 2007. Maybe by then we'll be back to the stock-market highs that occurred, yes, in 2007.