Companies finding it harder to manufacture profits

Over the next four quarters, the consensus of Wall Street analysts' estimated earnings growth rate is for a re-acceleration of earnings growth from about 7% to 17%. This seems unlikely, and exceeding these lofty estimates may prove nearly impossible.

Third quarter earnings are expected to be flat to slightly negative compared with a year ago. So far, 35 companies in the S&P 500 have reported earnings for the third quarter of 2012. This week, 80 companies are scheduled to report. While investors are very focused on what the profits were for the past quarter, it is what they may turn out to be over the next several quarters that will likely have the most impact on the markets.

Year-over-year earnings growth for the companies in the S&P 500 has slowed over the prior four quarters from 18% in the second quarter of 2011 to 8% in the second quarter of 2012, now followed by an expected -3% drop in earnings in the just-ended third quarter of 2012. Earnings expectations are now low enough that companies are likely to be able to beat them. Indeed, last week, global companies Alcoa and FedEx reported third quarter earnings that exceeded analysts’ expectations. However, investors should be cautious in extrapolating these beats to coming quarters.

Over the next four quarters, the consensus of Wall Street analysts’ estimated earnings growth rate is for a re-acceleration of earnings growth from about 7% to 17%. This seems unlikely, and exceeding these lofty estimates may prove nearly impossible. The stall in profit momentum is unlikely to be a mere one-quarter event. Not merely because the economic drag from some combination of higher taxes and spending cuts is likely to further slow the economy in 2013 from its currently sluggish pace of 1 – 2%, but also because of signs that demand and pricing gains have stalled. This can be seen in the recent release of the ISM (Institute for Supply Management) Index and this week’s release of the CPI (Consumer Price Index).

ISM Suggests Sluggish Environment for Economic Growth

The ISM is one of the best leading indicators for the economy and markets. The Institute for Supply Management is a group that represents purchasing managers at U.S. corporations. The ISM surveys these purchasing managers each month and publishes the results in the form of an index. Purchasing managers are at the front of the line when it comes to activity in manufacturing. Manufacturing companies need supplies to produce products, and purchasing managers order these supplies. When demand starts to pick up for manufactured goods, these managers need to order more supplies. Conversely, when demand pulls back, they respond by trimming their orders.

Although manufacturing businesses make up only about 40% of S&P 500 company earnings, demand for manufactured goods has been a timely barometer of business activity of all types. This index is published at the beginning of each month, offering one of the earliest signals as to how the economy and outlook for business is faring each month.

The long history of the ISM shows us how effective it has been in signaling each recession and recovery. While the ISM has given a consistent signal when the recession is ending, it has also signaled when the recovery momentum peaks and the economy and profits slow. Looking back at the ISM over the past 30 years, we can see that there have been a number of peaks and troughs that led the direction of profit growth. The index has typically troughed around 30 – 40 and peaked around 60. Currently at about 50, the ISM suggests a sluggish environment for profit growth. The level of the ISM Index indicates that earnings growth may be slightly positive this quarter, but unless it picks up meaningfully — which seems unlikely given the recession in Europe and slowdown in China among other challenges — profit growth is likely to be only half as strong as the consensus expects in coming quarters.

CPI Shows Businesses Having Trouble Raising Prices

A sign of weak pricing power by businesses can be seen in the Consumer Price Index, to be released on Tuesday. A year ago, the CPI was running at about 4% year-over-year, but now is only running at about 1.7%. Businesses are finding it increasingly hard to raise prices. In fact, the prices manufacturers pay — detailed in the Producer Price Index report released last week — shows that producer prices are rising faster than consumer prices. Limited job opportunities and after-tax income growth per capita in the United States of less than 3% are making it harder for companies to pass along higher prices to their customers. This is further depressing profit growth.

The trajectory of revisions to earnings estimates is likely to remain downward, despite companies exceeding profit estimates for the third quarter. This may limit the upside in the stock market during the earnings season, which runs from last week through the first couple of weeks of next month, and has typically been a time for above-average performance for the market.

Jeffrey Kleintop is the chief market strategist for LPL Financial. This commentary originally appeared on LPL’s website.