The ongoing housing slump and big losses at commercial and investment banks has prompted Standard & Poor's to estimate that operating profits for companies in the S&P 500 Index rose by a mere 1.9 percent during the third quarter. Compare that anemic profit growth to a 5.4 percent increase in the second quarter and 8.9 percent in the first.
Given that corporate profits ultimately determine stock prices, the big drop in profits suggests that stocks are over-priced and will fall sharply over the next couple of months.
Just last week, Washington Mutual, the largest U.S. savings and loan, announced that its third-quarter net profit fell approximately 75 percent, the result of a weakening housing market and disruptions in the secondary market. As fewer buyers sought mortgage loans, the S&L set aside $975 million to cover bad loans and reported losses and write-downs of $410 million on home loans and securities.
Merrill Lynch last week said that it expects a third-quarter net loss of as much as 50 cents a share on sub-prime mortgages and write-downs on collateralized debt obligations (CDOs). Meanwhile, Citigroup — the largest U.S. commercial bank — reported a third-quarter profit decline of 60 percent, mostly on $5.9 billion worth of losses on loans and mortgage-backed securities.
These troublesome earnings announcements follow similar reports from Morgan Stanley, Bear Stearns, and Lehman Brothers in late September. Those banks said declining profits have reduced the value of their loan commitments and mortgage-bond holdings. Bank of America recently reported that "unprecedented dislocations" in credit markets will have a "meaningful impact" on third-quarter results.
Smaller banks will not be immune, either, from write-downs on the sub-prime debacle.
Consumers have so far continued to spend heavily. But that could soon change. Even former Federal Reserve Chairman Alan Greenspan said in an interview last week that the biggest drop in housing prices since the Great Depression could soon lead to a slowdown in consumer spending.
If consumers tighten their belts, U.S. economic growth could come to a screaming halt. Consumer spending accounts for approximately 72 percent of the total output of goods and services in the U.S. (GDP).
Last week, two large U.S. retailers — Target and Lowe's — announced that their sales slowed during September. And share prices for retailers in general fell today, after several Wall Street analysts cut their September same-store sales estimates for department stores.
In light of these developments, I continue to urge you to not become complacent about the recent rally in stock prices. And, I strongly recommend you ignore the Wall Street "cheerleaders," who often appear to be more interested in increasing their own net worth rather than helping investors like you to generate profits in the financial markets.
On a brighter note, our new ETF service is positioned well for a decline in corporate profits and a potentially sharp drop in retail sales.