A deluge of falling prices will seem far heavier than anything a monsoon can produce

The beginning of July often is part of the early monsoon season in Africa, south western US and South Asia. For investors it marks the beginning of earnings season for the second quarter. The upcoming season could dampen profit expectations as much as the seasonal rainfall.
         
The recession that started in 2008 has brought instability, defaults, high unemployment and a lot of bad news. But one area routinely impressed investors: corporate profits. Despite the many challenges, businesses in almost all countries managed to delight shareholders with record profits. In the US corporate earnings have grown steadily since the bottom in 2009 and ascending into record territory last year. Earnings growth for US companies last year was 14% down from 39% in the post-recession spurt of 2010. Earnings forecasts for 2012 continue that optimism and expect the Standard & Poor’s (S&P) earnings grow to an all time high.
         
Recently the optimism has been tempered. As I pointed out in May many companies try to manage earnings in order to be sure that when they announce their earnings they beat analysts’ expectations. But this quarter it appears that pessimism is wide-spread. So far, there are 74 companies in the S&P 500 who have lowered their forecasts compared to 28 who have raised them a ratio of almost three to one. For US financials, the projected growth has fallen from 55.2% to 9.5%. The energy sector is no better. Their estimates have fallen by 5%.
         
But it’s not just the US. Forecasts are declining all over the world. Consensus forecasts were predicting 12% growth for Europe next year. Morgan Stanley reduced this to a fall of 8% this year followed by growth of only 2% next. The spectacular growth in Asia has begun to slow. According to Bank of America Merrill Lynch in June there were only 63 upgrades for every 100 downgrades.  
         
Over the past two months some large multinational companies in the US have been trimming expectations. One bellwether is FedEx. As an international shipper, its health can reflect the prospects for world trade. It recently reduced its forecast of $1.45 to $1.60 a share, which was well below expectations of $1.70. Procter & Gamble is usually considered a defensive stock. Even in bad times, people still have to buy soaps. But it recently issued profit warnings. The Olympic Games were not enough to boost global sportswear giant Nike. Inventories are rising in Europe and China, which will ultimately lead to discounting and lower profits.
         
The US company, Caterpillar Inc, manufactures machinery used in construction, mining, energy and other areas integral to growth. A large part of its sales are international, 9% come from China alone. In the final months of last year it sales were up 27%. These have slowed to 11%. Still analysts remain optimistic. The company projects record earnings and analysts generally haven't made big changes in their second-quarter estimates. Caterpillar believes that growth in the US will make up for loss of international sales even though the most numbers show tepid growth.
         
US companies are not the only ones that are having issues. The Economic Times in India reported that its analysis of 2,302 companies reported that revenue growth fell to 13.5% year-on-year, compared to 19.3 % in the previous quarter, and 17.8 % in the quarter to September 2011. According on analyst in Mumbai the second quarter “is going to be very rough—it will be a train wreck.”
         
China is certainly not in any better shape. The widely expected soft landing has turned decidedly hard. The much anticipated monetary easing has actually been going on for six months without much effect. The Chinese adamantly refuse to lift restrictions of construction for fear of exacerbating the housing bubble. But the construction industry makes up between 11% and 15% of the gross domestic product (GDP). As the US is discovering, it is difficult to stimulate an economy without a healthy construction industry.
         
Meanwhile the need for short-term loans has created myriads of unstable daisy chains based on a wide variety of overleveraged stores of commodities, everything from copper to soyabean to cement and heavy equipment, each used as collateral for other investments. So it is not surprising that the Shanghai Composite is valued at near its record low of 12 times last year’s earnings and 9.7 P/E of forecast earnings.
         
Last quarter managers were able to perform miracles managing analysts’ expectations. Over 79% of reporting companies posted earnings per share that beat analysts’ forecasts. This record has encouraged wildly optimistic forecasts of future earnings despite the global slowdown. These expectations will no doubt return to haunt the companies in the harsh light of reality. Present market valuations may be in for a large correction. A deluge of falling prices will seem far heavier than anything a monsoon can produce.

(William Gamble is president of Emerging Market Strategies. An international lawyer and economist, he developed his theories beginning with his first hand experience and business dealings in the Russia starting in 1993. Mr Gamble holds two graduate law degrees. He was educated at Institute D'Etudes Politique, Trinity College, University of Miami School of Law, and University of Virginia Darden Graduate School of Business Administration. He was a member of the bar in three states, over four different federal courts and has spoken four languages. Mr Gamble can be contacted at [email protected] or [email protected].)