Market catching up to company profits

The continuing tug of war between strong corporate earnings and generally negative economic news is shifting in favor of the earnings reports, suggesting an extension of July’s stock market rally, according to market analysts.

The 9.5% gain by the S&P 500 from June 30 through the first week of August is proof that the stock market is starting to catch up to five consecutive quarters of earnings that exceeded consensus estimates, said Douglas Cote, a senior market strategist with ING Investment Management.

“Earnings will continue to surprise on the upside because Wall Street tends to always have excessive pessimism after a big bear market,” he said. “Wall Street [optimism] tends to not catch up for at least five to six quarters, and that’s why third-quarter earnings, I expect, will once again greatly exceed consensus expectations.”

Mr. Cote cited the past two quarters as evidence of just how out of step Wall Street is with the actual strength of most public companies.

EARNINGS UP 50%

“The first and second quarters almost looked like twins in terms of earnings reports,” he said. “In both cases, the consensus estimate was for a 25% year-over-year increase in earnings by [S&P 500 companies], and in both quarters, the actual earnings were up more than 50%”

Strong earnings reports, however, are being offset by macroeconomic realities, including a 9.5% unemployment rate, soaring government debt and a weak housing market.

In May and June, most of the market momentum was tamped down by concerns about a sovereign-debt crisis sweeping across parts of Europe.

That kind of bad economic news is fueling a “disconnect” between the strength of many public companies and stock prices, according to Brian Gendreau, a market strategist for Financial Network Investment Corp., which has $18 billion under advisement.

“Earnings are strong, and the markets have not really reacted; that’s why stocks still look cheap,” he said. “In the short run, you can have this kind of disconnect, but in the long run, prices and earnings will move in sync.”

DOW COMPANIES STRONG

Mr. Gendreau pointed to the Dow Jones Industrial Average as an example of the generally overlooked strength of the equity markets.

Through the end of last month, with 23 of the 30 stocks in the index having reported quarterly earnings, a total of 19 companies had beaten the consensus estimates by an average of 9%.

One reason that some money managers and market analysts expect the stock market to be in a “trading range” over the next several months is that while they expect corporate earnings to continue to improve, they also expect the tug of war to continue in the form of a steady flow of discouraging economic news.

“There are two forces contributing to the ebb and flow of the stock market, but the [corporate earnings] seem to be winning out,” said Edwin Denson, head of market strategy at Singer Partners LLC, which has $130 million under management.

“We believe this dynamic will continue, because we don’t anticipate a quick turnaround,” he said. “We will continue to see slow economic growth and stubborn unemployment numbers, but it will be a steady grind forward and a grind ahead for the stock market.”

JOBLESS RATE A DRAG

One of the biggest head winds that are likely to mute investor sentiment is the steady flow of employment data representing an inability or reluctance by the private sector to add jobs.

“Companies are doing well — way better than analysts expected — but every day, someone will glean something negative from one economic report or another,” said Donald Schreiber, chief executive of Wealth Builders Inc., which has nearly $500 million under management.

“Investors would like it to all be over, but after the kind of cataclysmic economic crisis we went through, the economy is actually in amazing shape,” he said. “At the margins, there are a lot of positive things happening, but it will really depend on headline news and improving economic fundamentals, because investors are always over-focused on risk.”

Beyond the steady string of positive corporate earnings reports, skittish investors might also find some comfort in knowing that companies are flush with cash on their balance sheets, worker productivity is at record levels, and exports are increasing.

“We do see slow growth, but not anything like a double-dip recession,” said David Chalupnik, head of equities at First American Funds, which has $90 billion under management.

“The midterm elections should be another positive for the markets because it gets Washington away from policies and focused on election mode,” he said. “We see the stock market at the end of the year being higher than it is now.”

E-mail Jeff Benjamin at [email protected].