New York Market: Earnings quality deteriorates

US stocks may have trouble reaching records this week, as disappointing corporate profits batter confidence. "The quality of earnings has deteriorated," said Chris Davis of Davis Selected Advisers. "With the slow-down in Asia, there's a lot coming home to roost."

Second-quarter earnings growth, which was expected to be better than the first quarter's, was probably worse. And the Commerce Department said on Friday that the US economy slowed to an annual growth rate of 1.4 per cent in the second quarter from 5.5 per cent in the previous quarter.

The government said a drop in exports kept GDP low, an effect of an Asian recession that is also hurting US investors. With 84 per cent of the S&P 500 companies having reported second-quarter earnings, operating profits probably rose 2.9 per cent. That makes profit growth the slowest since the 1991 recession.

Looking ahead, the earnings picture is worsening, too. The dimming outlook has stocks stuck in a rut. For the month of July, the Dow Jones Index fell 0.8 per cent.

"The fundamentals now are beginning to make a difference," said Robert Doll, director of equity investments for Oppenheimer Funds. "Unless the earnings outlook can get better, the stock market will have a hard time moving higher."

A slowing economy and low inflation is just the mix that investors need, though, to keep buying Treasury bonds. "While growth is above forecasts, inflation is coming in lower than the scare levels that would snap this year's bond rally," said Barbara Kenworthy, bond manager at Prudential Investment Advisors. She sees 30-year bond yields falling to about 5.5 per cent - the lowest ever - as the economy cools. The benchmark 30-year bond yield closed at 5.72 per cent on Friday.

In the end, the slowdown in the US economy is seen as a positive for bond investors. That is because the Federal Reserve is not likely to raise borrowing costs. "Cheap imports have kept prices down and it gives the Fed a reason not to go,'' said Ken Anderson, bond manager at Evergreen Asset Management.

Still, some are concerned that a booming jobs market and soaring consumer optimism may yet lead to faster inflation. "It's still a battle," said Tom Seay, manager at Gradison-McDonald Asset Management. "I don't think the market as a whole offers any value right now, and a long bond back over 6 per cent wouldn't surprise me."

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