(Bloomberg) -- Deflation is helping U.S. companies get back on their feet, convincing some investors that stocks are poised to rise.
Wholesale costs declined by 4.6 percent last quarter, outpacing the drop in consumer prices by the most in seven years, according to data compiled by Bloomberg. The gap, a gauge of company pricing power, is more than double the six-decade average and the widest since September 2002, a month before stocks rebounded from a 2 1/2-year bear market and began a rally that doubled the value of U.S. equities.
Profits that topped analysts’ forecasts helped lift the Standard & Poor’s 500 Index 46 percent since March, the steepest advance since the 1930s. While bears say the improvement in earnings will falter as companies run out of costs to cut, LPL Financial, Manning & Napier Advisors Inc. and Pioneer Investment Management are betting the 38 percent drop in commodities will increase profitability and spur more gains in equities.
“Input costs have come down dramatically and it’s going to be one of the real engines that fuels this recovery,” said Burt White, Boston-based chief investment officer at LPL, which oversees $234 billion. “You could easily see an explosion in earnings that surprises and drives this market much, much higher.” White says the S&P 500 could “easily” reach 1,200 by year-end as raw materials fall and the economy recovers. The projection implies a 22 percent advance from last week’s close of 987.48. S&P 500 futures gained 0.2 percent today.
Presaged Gains
The last seven times the difference between consumer prices over producer prices peaked after widening 3 percentage points or more, the S&P 500 rose 19 percent on average in the next 12 months, Bloomberg data since 1948 show. That’s double the index’s average yearly gain of 8.3 percent over that span.
Lower costs won’t support earnings or stock prices unless sales also increase, according to Don Wordell, a fund manager for Atlanta-based RidgeWorth Capital Management, which oversees more than $58 billion. “I’m still very cautious on equities,” said Wordell, whose RidgeWorth Mid-Cap Value Equity Fund has outperformed 94 percent of rivals in the past five years, according to data compiled by Bloomberg. “For the market to have a sustainable, upward trajectory, you need revenue growth, and I don’t know where that’s going to come from.”
The first global recession since World War II may worsen as joblessness increases and the benefits of government spending wear off, according to economists such as Martin Feldstein at Harvard University.
Quarterly Declines
Profit for companies in the S&P 500 will fall 22 percent this quarter before a rebound in bank and brokerage income spurs a 62 percent increase in the last three months of the year, halting a nine-quarter earnings slump, according to analysts’ estimates. Excluding financial institutions, profits are projected to drop 8.4 percent in the fourth quarter.
That decline may be reduced by the fastest reversal in wholesale prices in at least six decades. Producer prices, which rose at the fastest pace in 27 years in 2008, slipped 3.2 percentage points faster than consumer prices last quarter.
Oil, copper and wheat all retreated more than 60 percent after climbing to records in 2008. The Reuters/Jefferies CRB Index of 19 industrial and agricultural commodities plummeted from an all-time high to a six-year low in eight months, losing 58 percent of its value.
Keeping More
The difference lets companies keep more money from each dollar of sales as the economy contracts, helping them preserve earnings even as they charge less to consumers, according to Manning & Napier’s Charles Stamey.
About 74 percent of S&P 500 companies surpassed analysts’ consensus estimates for second-quarter profit. Half trailed sales forecasts, based on the 353 that have reported results as of last week, data compiled by Bloomberg show. No more than 72.3 percent have ever beaten analysts’ estimates for a full quarter since at least 1993.
Lower input costs have been a “very good indicator of strong market returns,” said Stamey, a fund manager at Manning & Napier in St. Petersburg, Florida, which oversees $19 billion. “It’s really what allows companies to maintain or improve margins without significant price increases.” Manning & Napier, whose Pro-Blend Maximum Term Series Fund has beaten 98 percent of 576 large-cap blend funds tracked by Morningstar Inc. in the past 10 years, owns companies such as General Mills Inc., which Stamey says will benefit most as margins gain.
Ingredient Costs
The maker of foods from Cheerios cereal to Hamburger Helper and Yoplait yogurt raised its 2010 profit forecast because increases for ingredients and packaging will slow this year, Chairman and Chief Executive Officer Ken Powell said last month.
The Minneapolis-based company reported a 94 percent advance in quarterly net income as its gross profit, or sales minus the cost of goods sold, climbed to the highest level since at least 2000, according to data compiled by Bloomberg. General Mills retained about 42 cents per dollar of revenue after subtracting costs to produce its goods, the highest so-called gross margin in seven years. Dow Chemical Co. reported a second-quarter profit of 5 cents per share, topping analysts’ estimates for a 7-cent loss, as the largest U.S. chemical maker benefited from lower oil and gas prices. The Midland, Michigan-based company
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