Will Corporate Earnings Improve in 2008?

Following is an analysis by ING Investment Management that suggests that earnings outlook in 2008 might not be quite as dire as many might expect. 

Corporate Earnings: Look For An Improvement
by Brian Gendreau, ING Investment Strategist

At the beginning of the fourth quarter 2007, equity analysts were optimistic. The consensus was that earnings of the S&P 500 Index companies would grow by over 10% from a year earlier. But week after week as the quarter wore on, analysts marked down their estimates and the stock market followed the revisions downward. By the second week of February 2008, with most companies reporting, it was clear that earnings had actually dropped by over 22% in fourth quarter, a whopping 32% below the original estimated growth rate. For 2007 as a whole, it now appears that earnings declined by 1.9%, the first annual decline since the recession year of 2001.


Analysts Mark Down Earnings Estimates Sharply for Q4


These figures paint a pretty dismal picture. But no worries, equity analysts say — earnings will rebound in 2008, according to Reuters, growing by an estimated 15.4%. Are these estimates credible? Or does the forecasted rebound reflect little more than the natural tendency for analysts to leave estimates for more distant quarters untouched while marking down current and nearby quarters’ estimates?

The Consensus Expects an Upturn in Earnings in 2008

The reason earnings wound up being so weak in 2007 can be summarized in one word: financials. The weakness in the S&P 500’s earnings mostly reflects losses in the financial sector stemming from write-offs of subprime-related instruments. Without the write-offs, earnings would have risen by about 4.5%. Moreover, earnings rose in every sector other than financials last year, even in the beleaguered consumer discretionary sector that includes the automobile and homebuilding industries.

Implicit in analysts’ estimates for 2008 is an end — or at least major reduction — to the write-offs in the financial sector. Currently, analysts are forecasting that earnings in the financial sector will rise by 20% in 2008. Earnings in all other sectors, meanwhile, are expected to continue to grow in 2008. That, plus the effect of a low base of 2007 earnings, produces the projected 15.4% rise in earnings in 2008.

These estimates are obviously contingent on a re-acceleration of growth in the U.S. economy in 2008. This is consistent with the Blue Chip consensus view that real GDP growth will rise toward a trend-like 2.4% in the second half of this year. They are also contingent on growth remaining fairly strong abroad: Overseas sales now account for about half of the revenues of large-cap U.S. stocks.

This may all sound just a little too cheery to be believed, given the recent weakness in U.S. manufacturing and ongoing problems in housing and housing finance. But recent trends in prices and unit labor costs support the view that profits will pick up in 2008. Unit labor costs rose by only 1.1% on a year-over year basis in last year’s fourth quarter, the lowest growth rate in 15 quarters. This is important because labor costs account for about 75% of corporations’ expenses. Prices received by corporations, meanwhile, are holding up well. Export prices, for example, rose by 4.5% over a year ago in the fourth quarter. In other words it is likely that corporate profit margins in 2008 will widen, which bodes well for earnings growth.

Profit Margins are Likely to Rise in 2008

The bottom line: The outlook for earnings in 2008 is not as dire as last year’s weak results would suggest.

EconomicsRichard M. Todd