More Pain for Investors

With the dreadful fourth-quarter earnings season all but behind us, there's one thing we can say with certainty: U.S. profits will record their first back-to-back decline in nearly five years.

What's less certain is whether the first quarter, which has a little more than a month to go, will bring some relief after profits fell in both the third and fourth quarters.

Don't count on it.

As yesterday's ugly fourth-quarter results from Lowe's demonstrated, the housing slump is only beginning to leave its steel-toed boot marks on the bottom lines of Corporate America. Lowe's, the second-biggest home improvement retailer behind Home Depot, cited the “unprecedented” housing downturn in posting a 33-per-cent drop in profit.

And it warned there's more pain on the way.

“As we look to fiscal 2008, we know the next several quarters will be challenging on many fronts as industry sales are likely to remain soft,” said Lowe's chairman and chief executive officer Robert Niblock.

True, Lowe's stock rallied on the results, but that was only because the per share numbers, although awful, were a few pennies less awful than some analysts expected. It's hard to see how anyone can put a positive spin on a quarter in which same-store sales plunged 7.6 per cent. For fiscal 2008, Lowe's expects same-store sales to tumble by 5 to 6 per cent.

The ugly results from Lowes and other companies underline a key hurdle facing the stock market: How can stock prices rise when profits, a key driver of the stock market, have gone into reverse?

Lowe's has plenty of company. With 88 per cent of S&P 500 members having reported results as of last Friday, fourth-quarter profits are projected to plunge 21 per cent from a year earlier, according to Thomson Financial.

That is far worse than anyone predicted just a few months ago.

As of Oct. 1, profits were expected to rise 11.5 per cent, according to Thomson Financial. Why the massive reversal? A good deal of the blame goes to the financial sector, which has swung to an expected loss of $5.3-billion (U.S.) from a profit of $56.4-billion in the fourth quarter of 2006.

If the rapid deterioration in the earnings outlook has taught us anything, it's that estimates weren't nearly pessimistic enough to reflect the extent of credit-related losses piling up on Wall Street and spilling into the broader economy. Which is why the current first-quarter forecast – earnings are expected to slip just 0.3 per cent from a year earlier – should be viewed with suspicion.

Indeed, first-quarter estimates have already come down sharply, just as they did in the fourth quarter.

On Oct. 1, the expectation was that first-quarter profits would rise 10.6 per cent. By Jan. 1, the number had fallen to 5.7 per cent. Now, the projection has dipped into negative territory.

The trajectory here isn't encouraging. With tens of billions of subprime-related paper still sitting on the books of financial institutions, more writedowns are a certainty.

And that all but guarantees that the first quarter will be the third in a row in which profits tumble from year-earlier levels.

To be sure, there will be some pockets of strength. The technology sector, for example, is expected to post fourth-quarter earnings growth of 26 per cent, followed by energy, up 21 per cent.

As yesterday's triple-digit gains on the Dow Jones industrial average and S&P/TSX composite index prove, there's no shortage of hope out there. But until the profit recession shows signs of bottoming out for real, it's hard to see how such rallies can be sustained.