“The stock market has started the year with a bang, making some investors wonder what could possibly stand in the way of further gains,” writes E.S. Browning in today’s Wall Street Journal.

“One possible answer: earnings.”

“The expectation that corporate earnings finally will turn up after a year of thudding declines has helped spark a furious three-month stock rally. The Standard & Poor’s 500-stock index has jumped 21% since hitting a low on Sept. 21, and the Nasdaq Composite Index, whose resurgent tech stocks have been leading the way, has soared 45%.”

“On the face of it, earnings expectations seem to justify the optimism. Analysts are forecasting a jump of about 16% in earnings this year for the companies in the S&P 500, which looks impressive compared with the 17% earnings drop that the companies are expected to report for the year just ended, once fourth-quarter results are in.”

“The trouble is that the stock gains since Sept. 21 have been so sharp that much of the good news may already be built into stock prices – even if earnings expand. That could put a lid on any further run-ups this year, especially since significant earnings gains aren’t even expected until the second half of the year.”

“”We aren’t looking for a runaway market,” says Dennis Ferro, chief investment officer at Evergreen Investments, First Union’s mutual-fund unit who thinks the S&P 500 could go up 10% or less this year.”

“And that assumes that the analysts are right in their forecast for earnings gains this year. Charles Hill, director of research at Thomson Financial/First Call, which tracks analysts’ forecasts, says he still expects analysts to trim their expectations as the year progresses. He himself is forecasting just a 7.6% earnings gain this year, which means some investors could be disappointed.”

“Some analysts worry about an even darker scenario. They are concerned that what Federal Reserve Chairman Alan Greenspan once called “irrational exuberance” could creep back into the market, with greed once again replacing fear on Wall Street. That could push stock prices, and particularly tech-stock prices, back to levels that can’t be sustained by realistic earnings prospects.”

“Ned Davis Research, a market-research firm in Venice, Fla., has published a chart showing that the S&P 500’s performance from late 1999 through the present looks eerily like market performance from 1968-1970, when stocks soared, plunged and recovered, only to fall to new lows later.”

“Investors certainly seemed exuberant last week. After a drop on Monday, the last day of the year, stocks rebounded strongly in the new year. Overall, for the holiday-shortened week, the Dow Jones Industrial Average rose 1.21%, or 122.75 points, to 10259.74, including a rise of 0.86%, or 87.60 points, on Friday. The Nasdaq composite was up 3.63% on the week, and the S&P 500 gained 0.99%. Many money managers doubt that stocks could fall back to the lows that the major indexes hit on Sept. 21, after the Sept. 11 attacks. What they fear is simply that earnings growth, which most analysts think will prove weaker now than it was in the late 1990s, may not be strong enough to push stocks up a lot more this year, after the strong gains stocks put in late last year.”

“”Given a reasonable economic recovery, stock markets probably can deliver returns in the 8% to 10% range” this year, says Mr. Ferro of Evergreen Investments.”

“A 10% gain would disappoint those investors who came to consider 20% the norm during the booming 1990s. And Mr. Ferro worries that some individual stocks that don’t meet inflated earnings expectations could have a difficult year.”

“”There are companies that have bounced off the bottom for which a revised business case hasn’t yet been validated by increased orders and margins and profitability,” Mr. Ferro says. He points to optical fiber and telecommunications equipment companies in particular.”

“Mr. Hill of First Call takes that idea one step further. He notes that since current earnings have been depressed by the recession, some analysts consider it unfair to use these earnings as a reference point to gauge stocks’ fair value. It might be more appropriate, he suggests, to measure stock prices against forecast earnings for 2003, a time when earnings should be returning to normal. Even based on forecast 2003 earnings, Mr. Hill says, the current prices of tech stocks such as Cisco Systems, Microsoft, Intel and Sun Microsystems look high.”

@page_break@”Mr. Hill says that analysts expect Cisco, for example, to earn 39 cents a share in its fiscal year through July 2003. With the stock trading Friday at $20.83, Cisco is trading at 53 times expected earnings for 2003. Even accepting analysts’ forecasts that Cisco’s earnings will grow at 25% a year over the next five years, Mr. Hill says, that means that Cisco’s price-to-earnings ratio is more than twice its expected annual percentage earnings-growth rate. Many analysts would consider that a high valuation.”

“Or consider Intel, which traded at $35.79 on Friday. Analysts say it will earn $1.03 a share in calendar 2003. That puts the stock price at 35 times 2003 earnings, almost twice its expected five-year average earnings growth rate of 18%.”

“Microsoft is trading at 33 times its estimated per-share earnings of $2.09 for fiscal 2003, with a forecast earnings-growth rate of 15%. Sun is trading 61 times estimated 2003 earnings, triple its projected average earnings-growth rate of 20%.”

“Those P/E ratios aren’t as high as the 100-plus levels that some tech stocks commanded during the bubble, but tech-company earnings aren’t expected to grow as fast as they did in the late 1990s either. Current P/E ratios are high enough that Mr. Hill considers them hard to sustain.”

“And the calculations assume that companies deliver on the earnings that analysts currently project, which is hardly guaranteed.”

“As if that weren’t enough to give an investor pause, J. Thomas Madden, chief investment officer at mutual-fund group Federated Investors in Pittsburgh, suggests another worry: earnings quality. Analysts’ earnings estimates are based on what analysts call earnings from continuing operations, which tend to exclude some charges. Mr. Madden worries that the Enron debacle will cause investors to look harder at corporate earnings calculations, and could lead to more pain as some companies are forced to use more rigor in reporting earnings.”

“More companies’ earnings could turn out to be partly, at least, built on sand.”

“”One of the questions I continue to pose to our money managers is: Who else is going to be found wanting?” Mr. Madden says. “Long experience tells me that when you have an event that was as financially destructive as the collapse of Enron, you are getting a sea-change of attitude toward the quality of earnings, which has been an area of shortfall all through the 1990s. I am not persuaded that many [Wall Street] analysts pay enough attention to the balance sheet, even with the experience of Enron. I don’t believe that this stuff has been nearly enough attended to yet.””

Friday’s Market Activity

“Corning climbed 1, or 10%, to 10.70. The optical-cable maker said it would resume production of its products at two plants in North Carolina that the company idled last year amid a steep downturn in the telecommunications sector.”

“Conseco dropped 69 cents, or 16%, to 3.56. Salomon Smith Barney cut its rating on the Carmel, Ind., insurer and financial-services company to a “sell,” and set a price target on the stock of $1.”

“Several retailers rose, with Sears Roebuck up 2.11, or 4.4%, to 49.65, setting a fresh 52-week high. Best Buy gained 98 cents, or 1.3%, to 73.88. Gap advanced 1, or 6.9%, to 15.45.”

“Commodity products companies also marked progress, with Alcoa adding 1.16, or 3.2%, to 37.30, while Arch Coal went ahead 75 cents, or 3.3%, to 23.21.”

“Trucking concerns, a classic economy-sensitive sector, posted sharp gains. Nasdaq-traded Roadway added 2.88, or 7.8%, to 39.84, while CNF improved 1.46, or 4.4%, to 34.76.”

“Nasdaq-traded Adobe Systems jumped 2.82, or 8.5%, to 35.90 after J.P. Morgan boosted its rating on the San Jose software developer.”

“Online travel-services provider Travelocity.com lost 3.05, or 11%, to 24.39 on Nasdaq, after the Fort Worth, Texas, company lowered its revenue guidance for the fourth quarter.”