Earnings Estimates Coming Down Fast

Some Monday morning musings after a weekend of catching up:

Even stock analysts, a notoriously optimistic bunch, have now given up on a rebound in corporate earnings this year.

According to Chuck Hill of First Call, S&P 500 earnings will likely fall 17% this quarter from the comparable period a year ago. Companies are beating lowered estimates this quarter, but not by much. Third-quarter warnings are already on pace for a record, and analysts now expect a 9% drop in profits next quarter. For the fourth quarter – when comparisons begin to get easy and analysts had been expecting a strong rebound – estimates have plunged to a 2.4% gain, and will likely head much lower by the time the quarter arrives.

Just one more reason why stocks remain mired in a trading range here. Hill estimates that the S&P 500 is more than 15% overvalued at current levels, based on earnings and interest rates, a valuation method similar to the one used by the Federal Reserve.

There are more earnings reports on tap for this week, such as Check Point Software this morning, which is up 10% after topping lowered estimates, Amazon.com tonight, and GoTo.com Wednesday night, but the four reports that mattered – Intel , Microsoft , IBM and GE – were all disappointing. We devoted space to Intel, IBM and Microsoft, but not GE, which was a real head-scratcher: earnings were up 15%, but revenues declined by 3%. Watchdogs have said the company manages quarterly earnings to smooth out rough spots, and the disparity between earnings and revenue in the second quarter would seem to give some credence to that argument.

Speaking of analysts, the case filed by an investor who claims he lost money on InfoSpace because of Merrill Lynch analyst Henry Blodget’s buy rating on the stock has been settled for $400,000.

As Chris Nerney predicted in this space a few months ago, expect more to come. The floodgates have now been opened.

Thanks to some well-deserved publicity on the issue, the public now knows that analysts are under pressure to keep favorable ratings on stocks to boost investment banking and financial services business with those companies. That was the main claim behind the Merrill case.

Frankly, most analysts aren’t worth paying attention to anyway. Few of them are capable of calling – or are reluctant to call – turns before they happen, which is when the smart money is making its move. They wait until the evidence hits them over the head to change their rating on a stock, and by then it’s mostly priced in to the stock.

But the most shocking thing about the Merrill case isn’t about any alleged conflict of interest, but about good old-fashioned asset allocation and diversification. The investor in question turned $250,000 in Microsoft and AOL into $1.2 million, then switched that money into InfoSpace and JDS Uniphase in early 2000, just in time to lose more than 90% of that money. What that investor was doing with all his money in two stocks is the real question for investors. As we have stressed repeatedly, diversification and valuation matter. The Internet has put a tremendous amount of power and knowledge within reach of individual investors. Use it wisely and educate yourself.

And finally, the most interesting report this week could be Friday’s first look at second quarter GDP. Estimates range anywhere from a 1% gain to a 1% decline. Two consecutive quarters of negative GDP is the classic definition of a recession, so it should be interesting to see where Friday’s report comes in.

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