Whipsawed Wall Street traders see bullish sign in bad profit

NEW YORK – There hasn’t been much good news in U.S. corporate profits since they began sliding a year ago — until now.

At first glance, the earnings season that kicks off this week with Alcoa Inc. will be downright ugly. Net income is forecast to plunge 10 percent in the worst performance since the aftermath of the financial crisis in 2009. Yet, for the first time in eight months, the pace at which analysts are cutting their estimates is slowing. Improvement in the ratio between upgrades and downgrades foreshadowed the bottom of the earnings cycle in 2001 and 2008.

Evidence that earnings aren’t getting worse would be a welcome development for investors, who have endured a white knuckle ride in stocks this year as the Standard & Poor’s 500 Index plunged 11 percent through early February only to recover in an epic comeback not seen since 1933. While the turnaround in revisions could reverse, it usually doesn’t.

“Earnings are bottoming and they’re going to start rising,” said Paul Zemsky, head of multi-asset strategies at New York-based Voya Investment Management LLC, which oversees $210 billion. “I don’t think that’s fully priced in.”

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Equity rebound

More than $2 trillion was restored to equity prices over the last eight weeks as all but four of the S&P 500’s constituents bounced from their February lows. Besides calming nerves after the worst start on record, the rebound has pushed valuations back toward the highest level in six years, with the index trading at about 18.6 times profits. The benchmark gauge climbed 0.6 percent at 10:30 a.m. in New York.

Improving sentiment is visible in a Bank of America Corp. gauge of estimate revisions. The indicator tracks the number of companies whose yearly profit forecasts have been revised by analysts over the past three months. Higher numbers signal fewer cuts. On that basis, the measure flashed 0.53 for March compared with a seven-year low of 0.47 in February, the first increase since July.

Nothing happening now will do anything to salvage the current season that starts today with Alcoa, which is projected to say operating profit fell 92 percent to 2 cents a share. Analysts have been relentlessly lowering forecasts throughout the S&P 500 for the January-to-March period and estimate earnings will decline 10 percent from 2015 after carrying out the sharpest downward revision to estimates in six years.

Widespread weakness

While energy is expected to post the biggest retreat, weakness has spread to other industries. Banks, which as recently as August were predicted to see a 2.8 percent gain in first-quarter income, are now estimated to suffer a 16 percent tumble. Industrial company profits may fall 12 percent, compared with a projection for 4.2 percent growth seven months ago. Technology, consumer staples and utilities are all seen reporting lower earnings.

Based on analyst estimates, income in the S&P 500 isn’t expected to increase on a year-over-year basis until the third quarter — and that rebound has been repeatedly pushed back. As recently as December, analysts said profits would rise 0.5 percent in the January-to-March period. Estimates for the second quarter didn’t turn negative until February.

The earnings outlook is so cloudy that chasing the rally in U.S. shares is a bad idea, according to Andrew Slimmon, Chicago-based fund manager who helps oversee $5.1 billion at Morgan Stanley Investment Management. While U.S. jobs and manufacturing data are improving, rising risks overseas prompted Federal Reserve Chair Janet Yellen to signal that officials will be cautious in raising interest rates.

Validation needed

“If the overall estimates for the year start to go up because companies are more optimistic, we’ll change our tune,” Slimmon said. “But at this junction, we just haven’t seen it,” he said. “We will need to see some validation coming out of companies that the numbers are actually too low for the year.”

Determining the trajectory of earnings is crucial with equities stuck in the longest stretch of stagnation outside of a bear market since 1995. Down 2.7 percent from a year ago, the S&P 500 hasn’t seen a new high in 10 months. Even as the market sat still, the decline in profits has contributed to higher valuations.

“The market doesn’t show a propensity to rapidly increase multiples,” said Scott Jacobson, director of investment strategy at Hirtle Callaghan, which oversees $24.5 billion in West Conshohocken, Penn. “Gains will come with earnings growth,” he said. “I don’t think earnings have peaked. They may have paused.”

An uptick in analyst optimism has historically pointed to better profits ahead, or at least smaller declines. In January 2009, when Bank of America’s revision ratio rose from a record low of 0.09, earnings improved in each of the following four quarters to herald a six-year expansion. The measure’s ascent in November 2001 following a 18-month slide also preceded five quarters of growth acceleration.

Eight of 10 industries saw their earnings revision ratios go up in March, led by industrial and material producers. A decline in the dollar contributed to improved sentiment toward multinational firms, Savita Subramanian, Bank of America’s equity and quantitative strategist, wrote in an April 4 note. Meanwhile, oil finished March with the biggest increase in a year, easing pressure on energy profit.

“The question from here is, do you think earnings are going to keep tumbling lower, or do you think earnings are going to recover and we’re near the trough?” said Ed Clissold, chief U.S. strategist at Venice, Fla.-based Ned Davis Research Inc. “We think the worst of the earnings news is behind us and the market should continue to work higher.”

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