If Profits Propel Stocks, What Now?

When Intel Corp.'s earnings for the fourth quarter of 1997 beat expectations, the whole stock market cheered. Share prices rose last Tuesday.

Don't count on two more cheers.

Analysts are rapidly marking down estimates for 1998 corporate earnings, citing a slower economy and the Asian financial crisis.

Profits can be crucial to stock prices.

"With US stock market valuations near post war highs, earnings are likely to be the key to stock returns," notes Michael Flament of Wright Investors' Service, money managers in Bridgeport, Conn.

In the past three years, stock prices have surged along with an extraordinary rise in company profits.

Pretax profits, as a share of total national income, pushed above 10 percent last year, estimates John Youngdahl, an economist with Goldman Sachs & Co., an investment banking firm in New York.

That profit share was up from 6.9 percent in 1992 and the highest since 1968.

Few Wall Streeters expect this uptrend in profits' share of income to last.

Economists at Merrill Lynch now forecast earnings growth of 5.5 percent - down from 10 percent in 1996 - for companies in the Standard & Poor's 500 index, a broad measure of the market.

That still represents an unprecedented seventh consecutive year of profit growth.

Because of the shakier profit picture, says Merrill Lynch chief economist Bruce Steinberg, investors will keep reassessing the outlook and stock prices will remain volatile for the next three to six months.

"Later in the year, perhaps there will be a turnaround [in prices]," he says. "It is far from an awful situation."

In March, the economy will enter its eighth year of expansion. By September, the upturn will beat the peacetime expansion record of the 1980s. And next year should be better, Mr. Steinberg says.

Wall Street looks at profits two ways.

Economists, such as Steinberg and Flament, give "top-down" forecasts of the economy. While stock analysts make "bottom-up" forecasts for companies that make up an index, such as the S&P 500.

The latter tend to be overly optimistic.

"Bottom-up figures always look fabulous," notes H. Bradlee Perry, a consultant to David L. Babson & Co., money managers in Cambridge, Mass.

Some forecasts for 1998 call for 12 to 14 percent growth for the S&P 500. Looking at the 30 stocks in the Dow Jones Industrial Average, analysts for Value Line see earnings up 15 percent in 1998.

But, cautions Value Line's research chairman, Samuel Eisenstadt, "Nobody has a firm fix on the impact of the Asian thing, other than it will lower earnings."

Wall Street economist Arnold Moskowitz expects stock prices to rise 15 to 20 percent this year, despite weaker profit growth. He's been highly bullish in the last two years - and right on.

His optimism arises from several factors: moderate economic growth (a 2.3 percent real gain in 1998 output), inflation between 1 and 2 percent, strong employment growth, an expectation that long-term interest rates will fall to 5 percent (currently 5.8 percent), technology-driven gains in productivity, a strong dollar, and a modest pickup in European economic growth.