Will Earnings Growth Support The Stock Market?

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With anxiety mounting about Europe’s debt crisis, China’s growth, and renewed talk of a double dip recession in the U.S., the stock market is losing steam. As the Dow dips below 10,000, buyers are not charging in to scoop up values, leading many to ask whether market’s weakness reflects mere worry or  is the accurate refection of a deteriorating profit outlook for U.S. companies.

Investor worry by itself is not a big concern because the stock market, as the saying goes, likes to climb a wall of worry. But what could be real trouble for stocks is a falloff in profits, since rising earnings along with low interest rates is the big driver of capital gains. Interest rates, by most lights, are not going much higher in the near term due to the fact that deflation is more of a threat than inflation, and the world economy is slowing. Earnings growth is another matter.  A new report from Merrill Lynch deconstructs the S&P500 earnings to find where changes to earnings growth might be most pronounced. While Merrill’s economists and strategists expect no change in the aggregate number–they expect earnings of $80 for the S&P 500 in 2010–they are looking for  plenty of change beneath the surface.  Here’s a quick take:  To reflect lower oil prices, Merrill’s profit-growth estimate for the energy sector is reduced 10%.  Reflecting lower earnings from Europe, the growth estimates for industries with a relatively heavy Europe exposure, such as Beverages, Household Products and Fast Food Retailers, are trimmed as well.   Technology also suffers a bit of Euro-related weakness, but this is mostly offset by renewed strength in global tech sales.

The big winner in Merrill’s rehash of the 2010 earnings growth story is..curtain, please…financial companies. The group, which includes banks, is the huge winner in this low interest rate environment since banks can pay almost nothing for deposits and then make loans to good-credit borrowers at juicy spreads. The overall financial group is enjoying a 3.7% bump up in its earnings forecast from Merrill’s analysts. This may not sound like that big a boost, but financials are the second biggest contributor to S&P 500 profits after technology, so an upgrade in financials profits matters hugely.

The earnings-outlook news is encouraging but it is not carved in stone, and it depends on the U.S. economy delivering a healthy 3.2% annual growth for the year, according to Merrill. The bigger issue is this:  If inflation should rear its head that could lead to a quick boost in interest rates, which would undercut the most positive earnings story out there right now, from financials. So keep one eye on the financial headlines about Europe, China and all the rest, but keep the other eye on the price of things.