Can the profit boom last?
Businesses have been churning out earnings. But with energy prices and interest rates rising and consumer confidence sinking, tougher times are ahead.
By David Stires

(FORTUNE Magazine) – THERE WON'T BE CHAMPAGNE AND speeches to mark the event, but corporate America is about to make history. For the quarter ended Sept. 30, companies in the S&P 500 are expected to boost earnings by 15% compared with the same period a year ago, marking the 14th consecutive quarter of double-digit profit growth--a new record. If estimates hold, earnings per share for S&P 500 firms will have increased a phenomenal 70% during this 3½-year stretch, making it one of the greatest profit booms ever. And the S&P 500 index has gained 23% during that time.

The performance is all the more remarkable when you consider the litany of profit-crimping obstacles, from devastating hurricanes and soaring energy costs to 11 rate hikes by the Federal Reserve. The fact that companies have overcome it all offers telling testimony to the health of the global economy, the magic of low interest rates, and the power of corporate cost cutting.

Alas, this robust growth spurt seems destined to end soon. Wall Street analysts forecast that corporate profits will rise 14% in the fourth quarter, but for 2006, they expect growth will gradually drop to a more traditional rate, somewhere in the high single digits. Admittedly, investors have already factored in some of the expected slowdown, which is why stocks have languished all year. But with new problems continually popping up--from plunging consumer confidence to rising inflation fears--a few market watchers are now warning there's big trouble ahead. "We could be in store for 1%-ish growth next year," says David Rosenberg, North American economist at Merrill Lynch. He's taken his estimate for S&P 500 profit growth down to 2% next year. "Something tells us that equity valuations are not priced for such an outcome."

The headwinds facing stocks begin with soaring energy prices. While fuel costs have retreated from their highs following last month's gulf storms, they are still up dramatically from a year ago. At $65 a barrel, oil has risen 45%. Gasoline, at $2.80 per gallon, is up 50%. The price of natural gas, which most families use to heat their homes, has doubled in the past year. All told, households are on pace to spend an average of $4,600 on energy this year, according to Global Insight, a research firm. That's up about $600 from last year and $1,000 more than in 2003. That extra grand will take about $112 billion out of consumers' pockets, giving them that much less to spend on restaurant meals, clothing, and other discretionary items, choking off economic growth.

We're just beginning to see the effects of those cutbacks. According to the International Strategy and Investment Group, a Washington, D.C., research firm, the full effect of a sustained spike in oil prices takes about a year to trickle through the system. So oil's ascent to $40 and $50, which took place from late 2004 through early 2005, is still working its way into the economy--and the full impact of the recent rise to $65 oil won't be felt until 2006.

At the moment, Fed chairman Alan Greenspan seems more concerned about the risk of higher inflation than slower growth. On Sept. 20 the Fed raised short-term interest rates for the 11th time since June 2004, bringing the Federal funds rate to 3.75%. Most economists approved of the move, particularly in light of President Bush's pledge to spend some $200 billion to rebuild communities along the Gulf Coast--a capital infusion likely to ripple nationwide. Ken Simonson, chief economist for Associated General Contractors of America, predicts construction-related materials prices will rise 10% next year, up from a previous forecast of 6% to 8%. He blames higher fuel and transportation costs, and disruptions and shortages related to Hurricane Katrina.

A couple of other worries for investors: First, stocks aren't cheap. The S&P 500 trades at 19 times the past 12 months' reported earnings, or about 25% higher than its long-term average P/E of 15. Second, the current bull market is old. Ned Davis Research marks the start of this one on Oct. 9, 2002, which means it has run for 1,087 days (as of Sept. 30, 2005). That's far longer than the 614 days the median cyclical bull has lasted since 1900. Moreover, this market is following the classic pattern, rising sharply in the first couple of years and then trailing off, suggesting that it is entering its final phase.

That brings us back to the profit boom. Henry McVey, U.S. investment strategist at Morgan Stanley, recently published a study looking at the 20 longest-running bull markets since 1928. He found that about 70% of the market's performance during those periods came from expanding price/earnings ratios, while the remaining 30% came from profit growth. This time more than 80% of the market's price appreciation has come from growth in earnings. In other words, this has been a ferociously earnings-driven bull market. That's not necessarily a bad thing, but the aftermath of such rallies tends to be "particularly painful," McVey says. His research shows that on average, the S&P 500 falls 12% in the year following the end of a profit-driven rally, vs. 7% for a P/E-driven market.

When that correction will occur is anyone's guess. McVey, for his part, recommends that investors play it safe by avoiding economically sensitive areas of the market that are likely to tumble during a correction. One strategy he favors is buying stocks with stable earnings and rich dividend yields, such as Altria (MO, $73). Shares are up 25% this year, but they still sell for just 15 times earnings, well below other consumer products firms. Lawsuits against cigarette maker Philip Morris continue to weigh on the stock, but the litigation environment has improved substantially in recent years, making the company's expenses far more predictable. Meanwhile, the stock offers a rich 4.1% dividend yield.

Health care is one of McVey's favorite sectors. Fueled by growing demand from an aging population, sales and earnings at many medical firms are climbing at a rapid clip. And health care, which faces fewer cyclical pressures than nearly any other sector, remains a defensive investment if the market goes south. Doug Eby, co-manager of the Torray fund, which has outperformed 95% of all large blend funds for the past ten years, according to Morningstar, recommends medical-device giant Medtronic (MDT, $54). With $10 billion in sales, the company dominates the heart-device industry. It makes an array of implantable products, from pacemakers to heart valves--a business with high barriers to entry and fat margins. It trades at a 20% discount to the market based on price to free cash flow, Torray's preferred metric. Annual profits are expected to grow a healthy 15%.

Considering the stretched valuations in the U.S., fund managers are increasingly looking abroad, where shares are cheaper. David Williams, manager of the Excelsior Value & Restructuring fund, which has gained an annualized 26.7% for the past three years, likes Petróleo Brasileiro (PBR, $73). Petrobras, as it's known, is the state-owned oil company of Brazil, which is enjoying solid economic growth. He points out that at eight times current earnings, the stock's P/E is a fraction of those of major integrated oil companies like Exxon Mobil, which trades at 13 times earnings.