Meltdown 101: At a quarter’s end, earnings warnings can bring new ideas about the economy

By Tim Paradis, AP
Thursday, July 9, 2009

Meltdown 101: Why do earnings warnings matter?

NEW YORK — It’s report card season on Wall Street and investors are bracing for bad news.

With the April-to-June quarter over, this is the time when companies could come out with warnings that their earnings will fall short of expectations.

Traders watch for these earnings warnings because disappointing results can sink a stock and realign expectations for an industry. They can even offer clues about the future of the overall economy.

Here are some questions and answers about earnings warnings.

Q: What are these warnings?

A: Companies are required to let investors know of significant shifts in their business. So if a company forecasts it will hit a particular target, and later expects to be far off that mark, they’ll often issue a statement or submit a filing to regulators saying so.

Q: Why do they matter?

A: Investors buy stocks to get a slice of a company’s future earnings. If a company’s profits are slipping or its business looks less stable, investors might turn and run.

Q: What if I don’t own the stock of a company that warned? Does it still matter to me?

A: It depends. A company might throw up a caution flag and only its stock gets hurt. But when important players deliver bad news it can drag down an industry or even the whole market.

Chip maker Intel Corp. helped drive the Dow Jones industrial average down by 245 points on Jan. 7 after the company said revenue for the final three months of 2008 would come in about $500 million below its forecast. It was the company’s second warning since November and sent Intel shares skidding 6 percent.

The overall market tumbled because investors were concerned that this was a sign of trouble across multiple industries.

Q: Does a company’s reputation affect how investors will digest its comments?

A: It can. Traders have ideas about how different companies operate, so a warning from Apple Inc., for example, could hurt a range of stocks in part because it is known for being conservative when it issues forecasts. If a company like Apple has to put out a warning, the theory goes, that might be a sign that serious trouble is afoot.

Jerome Heppelmann, portfolio manager of the Old Mutual Focused Fund, said traders listen more to some companies than others.

Cisco Systems Inc., the world’s biggest maker of computer networking gear, startled investors in early November when it said orders had fallen abruptly in October. Those comments were part of the reason the Dow plunged 440 points the next day.

“John Chambers at Cisco has a reputation for being such a straight talker,” Heppelmann said. “So what he says will be dissected and listened to a little bit closer to than some others.”

Q: Sometimes a company says its earnings will meet expectations but the stock still falls. Why?

A: Look for a forecast from the company — chances are that, and not the earnings report, is what’s driving the stock. By the time a quarter ends investors often have a good sense of how a company did, so the earnings report might not have any surprises. What investors are hungry for — and likely to react to — is any hint of how the coming quarters will unfold.

“Every word is going to be parsed by investors,” said Jeffrey Kleintop, chief market strategist at LPL Financial in Boston, referring to the earnings warnings and forecasts that might emerge in the coming weeks.

Earnings warnings could hit stocks more than normal in the next few weeks because investors are on edge as they try to determine how long the economy will take to rebound. A particular source of nervousness is the rise in stocks in March and April on hopes of an economic turnaround; some investors question whether the increase was justified.

The market has given back some of that advance but the benchmark Standard & Poor’s 500 index is still up 30 percent from a 12-year low on March 9.

Q: Do investors always dump a stock when a company says results will miss expectations?

A: No. Companies can warn that a quarter’s results won’t be that good and the stock can still rise if the company can convince investors that the coming quarters will show improvement.

Q: Can earnings warnings ever help the overall market?

A: Sometimes the bad news can help keep investors’ expectations from getting too lofty.

Kleintop likes to see the stock market pull back before earnings reports start to rush in because it can make room for a rally later.

“In the few weeks before we get to the bulk of the reports — if the market goes down over that period of time usually it means the bar is being lowered,” he said.

Q: When companies come out with an announcement about their performance, is it always bad news?

A: No, sometimes companies surprise investors with word that they expect to do better than previously forecast. That can help stocks as well.

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