Wall Street turns to fundamentals, and the picture sours

Reuters

By Rodrigo Campos and Julia Edwards

NEW YORK (Reuters) - It's back to basics on Wall Street after the default debacle was kicked down the road, but in the early going after that cloud was lifted, investors have found corporate America's numbers wanting.

Just as the market breathed a sigh of relief as a debt-limit agreement was reached on Wednesday evening, it was socked in the jaw by earnings from Dow component IBM (NYS:IBM - News).

Big Blue, as it is commonly known, was joined by a pair of underwhelming results from fellow Dow members Goldman Sachs (GS.N) Group Inc and UnitedHealth Group Inc (NYS:UNH - News). All three stocks were lower Thursday, and taken together accounted for about 120 points of losses on the Dow, even though the S&P 500 was marginally higher.

A number of bellwether names have been a drag on stocks so far, including IBM, Yahoo and J.P. Morgan Chase & Co. (NYS:JPM - News)

Overall earnings growth is expected to come in at just 2.1 percent for the third quarter, down from an estimated 4.5 percent at the beginning of October. Forecasts have been on the wane with the growth picture muddied and as margins come down.

That means the market's rally is largely going to come as a result of investors who believe stocks are still undervalued based on hopes for future growth.

"The stock market's expansion this year has been driven by multiple expansion rather than material improvement in underlying fundamentals. That's why people do take a lot from IBM," said Adrian Cronje, chief investment officer at Balentine in Atlanta.

Data show the forward price-to-earnings ratio on the S&P at near 14.5, which is around the highest its been in four years, a shade under the long-term mean of 14.85. This may be helping fuel the market's run to record highs, but if weakness in earnings continues, that P/E will rise, and could make themarket look expensive.

Researchers at Goldman Sachs, in a note Thursday, said that profit margins before interest and taxes - excluding financials - have dropped for seven consecutive quarters prior to this one.

IBM said profitability in its hardware business declined by $1 billion from a year ago, and missed revenue expectations by about $1 billion as well. Shares opened at a two-year low on Thursday.

When it reported earnings, Goldman Sachs said third-quarter revenue plunged 20 percent on mortgage and bond-trading results, but profit dropped only slightly as the Wall Street bank slashed compensation and other expenses.

"If markets continue to stay where they are, you have to keep paying a higher multiple for the same levels of fundamentals, which does make the market more vulnerable to disappointing news," Cronje said.

Revenue estimates for the third quarter have dropped steadily and are now at 2.6 percent for the quarter, according to Thomson Reuters data. So far, 55 percent of the 79 S&P 500 components that have reported have beaten revenue estimates, below the 61 percent average since 2002.

From a more technical perspective, IBM's performance after earnings is a harbinger of weakness in the next few weeks as well. A drop in IBM shares one day after results predicts a decline in the S&P 500 five weeks down the road about 75 percent of the time, according to Bespoke Investment Group, an investment research firm in Harrison, New York.

"No other stock in the S&P 500 has been more consistent over the last 12 years in accurately predicting the performance of the S&P 500 over the following five weeks," Bespoke said in a note on Wednesday.

Looking forward the picture doesn't get better as the fourth quarter didn't get off to a great start. The 16-day government shutdown and threat of default was expected to cut about 0.6 percent from gross domestic product growth, further hurting corporate earnings.

The disarray in Washington has also helped keep the Federal Reserve's stimulus in place, which has pushed traders to buy any market declines on expectation that the flow of cheap money will keep equities trending higher.

(Reporting by Rodrigo Campos and Julia Edwards; editing by Andrew Hay)

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