The next shoe to drop in what has become known as the subprime mortgage mess will be third-quarter corporate financial reports.
On Wednesday, Standard & Poor’s estimated that third-quarter profits for the S&P 500 index will be up just 2.4 percent from the third quarter of 2006.
That’s the weakest year-over-year increase since the first quarter of 2002, when the economy was emerging from a mild recession and the 9/11 attacks.
Robust corporate profit growth has been the centerpiece of the U.S. economy for five years. Even in the second quarter of this year, amid the onset of the credit crunch, S&P 500 profits climbed nearly 10 percent.
Quarterly profit growth for this basket of major companies was greater than 10 percent for 18 of the last 21 quarters.
The biggest drag on third-quarter results, which will begin to emerge next week, likely will be the performance of financial-services firms, especially mortgage lenders, consumer finance companies and investment banks.
“Financials are going to be the focus sector this time around,” said John Butters, analyst for Thomson Financial. “How accurate the analysts are in predicting the impact, we’ll have to see.”
Some of the coming results probably will disappoint investors, based on third-quarter earnings-per-share estimates by financial-services stock analysts with superior forecasting track records, as compiled by StarMine.
For example, the forecast by top-rated analysts of Bank of America’s earnings per share for the third quarter, which ends Friday, is 9 percent less than the consensus estimate of all analysts who track the stock. Similarly, the top-rated analysts’ forecast of mortgage giant Washington Mutual is 6 percent less than the consensus outlook.
A second concern is the extent to which subprime mortgage problems have spread to non-financial companies. Results by General Motors and Ford, for example, have been hard to predict in recent quarters, Butters noted. Several major retailers, including Target and Lowe’s, have predicted weak sales in September.
A positive earnings surprise might be delivered by energy stocks, if the recent run-up in oil prices to record highs flows to the third-quarter bottom line.
A new pitfall for investors who study quarterly reports arises from a new accounting rule regarding changes in the so-called fair value of balance sheet assets.
Companies, including lenders, are required to reduce the value of assets, including loans, if the marketability of the assets erodes. The loss must appear on the income statement as a hit to earnings.
If the asset is a highly liquid common stock, such as International Business Machines, the fair value is relatively easy to assess at any time. But what if stock exchanges suddenly delisted IBM?
In just this way, the marketability of certain loans held by lenders has nearly evaporated in recent weeks.
How financial firms account for the problem will make interesting reading, if you enjoy the fine print.
“They’ve got to come up with a rationale for it. There’s a lot of potential surprises on the downside,” said Howard Silverblatt, senior index analyst for Standard & Poor’s. The impact of the change could be even greater in fourth-quarter reports, he said.
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