Profits matter most for U.S. stocks as economy fixation dims

Profits (SPX) are moving U.S. equity prices more than any time since the bull market began 3 1/2 years ago, rewarding investors for picking stocks based on company data instead of following the herd rocked by Europe’s debt crisis and the slowing U.S. economy.

Companies in the Standard & Poor’s 500 Index rose or fell an average of 4.4 percent the day after releasing results since July, according to data compiled by Bloomberg. The last time they moved more was in the second quarter of 2009. Daily swings in the benchmark gauge narrowed to 0.4 percent last month from 2.2 percent a year ago, as economic and policy changes battered investors. More than 475 S&P 500 stocks moved in the same direction in six of the first nine days of August 2011, with all 500 down on Aug. 8.

Bulls say lockstep moves are diminishing because investors are changing their behavior, making choices based on corporate results at a time when analysts estimate profits for companies in the S&P 500 will rise almost 10 percent a year through 2014. Bears say the focus on earnings won’t bring back individuals who have drained more than $420 billion from U.S. equity mutual funds over the past four years even as stocks rallied 108 percent since March 2009 and net income was unchanged in the second quarter.

“I’m not saying it’s an easy job to be a stock picker in this environment, but it’s certainly easier,” Sandy Lincoln, the Chicago-based chief market strategist with BMO Global Asset Management, which oversees about $100 billion, said in an Aug. 28 interview. “Stock selection does have the opportunity here to finally show a face with a smile.”

Calm markets

Earnings matter more as concern about Europe’s debt crisis eases following European Central Bank President Mario Draghi’s pledge to defend the euro. The S&P 500 fell 0.3 percent last week to 1,406.58, trimming the 2012 gain to 12 percent, as evidence of a global economic slowdown overshadowed speculation the Federal Reserve will introduce stimulus measures. Futures on the index rose 0.1 percent at 9:29 a.m. in London today.

Fed Chairman Ben S. Bernanke said on Aug. 31 in a speech to central bankers and economists at an annual forum in Jackson Hole, Wyoming that a new round of bond purchases is an option, citing unemployment of more than 8 percent as a “grave concern.”

The S&P 500’s 1.9 percent gain on Aug. 3 was the month’s only daily swing greater than 1 percent, compared with nine such fluctuations in June, data compiled by Bloomberg show. While markets calmed, MetroPCS Communications Inc. (PCS), Western Digital Corp. (WDC) and eight other companies rose or fell more than 20 percent on the day after reporting earnings.

MetroPCS jumps

MetroPCS, a pay-as-you-go wireless carrier, posted a 76 percent increase in earnings on July 26 as the Richardson, Texas-based company cut sales-promotion costs amid a slowdown in new customers. The result exceeded estimates by the most since 2009, sending the stock up 37 percent.

Western Digital, based in Irvine, California, surged 21 percent after the maker of disk drives and networking products reported profit that surpassed forecasts on July 25. While the result beat projections by 37 percent, in line with the five- year average, the price move was three times as big as the rate since 2007 after releasing results.

Baker Hughes Inc. (BHI), the world’s third-largest oilfield services provider, rallied 9.2 percent on July 20, when the Houston-based company said improved results from North America beat analysts’ estimates. The same day, the S&P 500 declined 1 percent as Spain said the recession will extend into next year and concern about its regional governments’ finances grew.

AMD, WellPoint

Earnings that trailed forecasts exerted more influence too. Advanced Micro Devices Inc. (AMD), the second-biggest maker of processors for personal computers, slumped 13 percent the day after income from the Sunnyvale, California-based company missed analyst estimates for the first time since 2009. The move was more than twice the average price change.

Shares of WellPoint Inc. (WLP) slipped 12 percent after the Indianapolis-based health-plan provider reported profit that fell short of projections, while a disappointing quarter for International Game Technology (IGT) led to a 20 percent drop in the shares.

“When some company breaks the monotony with a good or bad earnings report, you get an exaggerated reaction,” Ben Fischer, the Dallas-based managing director at Allianz Global Investors, which oversees 291 billion euros ($366 billion), said in an Aug. 30 phone interview. “There’s an event that you can get your teeth into, and then you get these huge reactions.”
Exceeding Forecasts

Stocks moved more after earnings even as analysts did a better job forecasting the results. Profits exceeded estimates by 4.5 percent on average last quarter, compared with 6.2 percent in the prior period, data compiled by Bloomberg show.

The increased focus on earnings is a challenge to investors because analysts are too optimistic about 2012, according to Chris Hyzy of U.S. Trust, which oversees about $325 billion. He predicts S&P 500 profits will reach $100 a share this year, compared with the $103.1 average of more than 10,000 estimates compiled by Bloomberg.

Earnings were unchanged in the March-to-June period, failing to grow for the first time since 2009, while the index’s price-earnings ratio rose 2 percent to 14.3, compared with the five-decade average of 16.4, data compiled by Bloomberg show.

Profit rebound

While profits may decline 1.7 percent this quarter, they will rebound 11 percent in the final three months of 2012 and rise 11 percent next year and 12 percent in 2014, according to analyst estimates compiled by Bloomberg.

“The anchor to stock-price movement is without question profit,” Hyzy, New York-based chief investment officer of U.S. Trust said in an Aug. 29 phone interview. “Earnings will be good, but they won’t be as high as expected and the market should fade.”

Investors are focusing more on earnings after being whipsawed for four years by the financial crisis and Europe’s struggle to manage sovereign debt. The average daily move in the S&P 500 was more than 1.3 percent between April and December of 2011, twice the five-decade average, as concern about budget deficits in Greece, Portugal and Italy drew attention away from individual companies.

Greater sensitivity to earnings is reducing the degree by which stocks rise and fall in unison. The so-called correlation coefficient among S&P 500 companies fell to 0.58 on Aug. 31, down 14 percent from a month ago, according to data on the 50- day rolling average compiled by Westport, Connecticut-based Birinyi Associates Inc. A reading of 1.0 indicates they’re all moving in the same direction by the same amount.

Stock correlation

Correlation reached a record 0.86 percent in October, Birinyi data dating back to 1980 show, after S&P downgraded the U.S. government’s AAA credit rating, sparking concern the world’s biggest economy may slip into its second recession in three years. American equities lost $1.51 trillion in value over the two months through Oct. 4. Since then, more than $3 trillion has been restored as U.S. bond yields hit record lows, repudiating S&P’s decision.

The link among stocks usually increases when the market is falling. The last two times correlation rose above 0.8 coincided with the bull market’s biggest retreats, Birinyi data show.
Debt Crisis

The S&P 500 fell 19 percent and 16 percent, respectively, in 2011 and 2010 as concern about Europe’s debt crisis led to near-lockstep swings in equity prices. Correlation reached 0.83 in October 1987, when the S&P 500 plunged 29 percent over four days.

Weakening correlations may lure back investors, who have lost confidence in equities after the dot-com tumble, the U.S. real-estate collapse, the worst financial crisis since the Great Depression and the so-called flash crash in May 2010 when $862 billion of market value was briefly wiped out, according to Birinyi Associates.

Even as the S&P 500 doubled, investors pulled money from mutual funds that buy U.S. stocks for a fifth year in 2011, the longest streak in data going back to 1984, according to the Investment Company Institute, a Washington-based trade group. Withdrawals were $135 billion last year, the second-highest total after 2008, and about $75 billion has been pulled in 2012, ICI data show.

Bond inflows

While investors were pulling money out of equity funds, they were pouring it into bond funds, which have seen about $200 billion in inflows this year, ICI data show. Bond managers have received about $910 billion since March 2009, even as the S&P 500 rallied 108 percent.

“Equity investors are exhausted, disappointed and in many cases unfulfilled based on some excessive promises that were made to them a decade or more ago,” Lawrence Creatura, who helps oversee $356 billion as a Rochester, New York-based fund manager at Federated Investors Inc., said in an Aug. 30 phone interview. “But the math which drives returns in the equity market still exists, much like a physical law,” he said. “If companies do continue to post higher profits, higher equity returns will follow.”