LONDON (Reuters) - The second-quarter corporate earnings that are due to hit the headlines over the next few weeks may have to beat even the most optimistic expectations to prompt investors to seek more equity after a stellar quarter.
The three-month rally in world stocks has stalled in the past week or so on doubts over the strength and sustainability of a global economic recovery, taking the benchmark MSCI index down 6 percent from its early June peak.
And with the quarter as a whole still on course to record the biggest stock price gains in more than 10 years, the temptation to book profits looms large.
What is required to re-ignite the rally is specific -- and ample -- evidence that the economy is generating a self-sustaining rebound and corporate profits are recovering.
Expectations for earnings and profits are still high, even after analysts steadily revised them down last year.
According to ratings agency Standard & Poor's, operating earnings per share of the benchmark U.S. S&P 500 index .SPX are expected to grow by 13 percent to $55.81 in 2009 and a further 33 percent to $74.32 in 2010, having fallen 40 percent to $49.51 in 2008.
According to Thomson Reuters data, quarterly earnings are estimated to drop 34.5 percent for the S&P 500 index for the second quarter -- downgraded from 27 percent growth in July 2008 -- and fall by 21.4 percent in the third quarter.
Come fourth quarter, however, the earnings growth rate is somehow expected to hit a whopping 180.2 percent -- thanks to some impressive optimism about firms selling discretionary consumer goods and material firms.
For full-year 2010 the rate is expected to rebound to 26.3 percent growth from the 11.2 percent fall estimated for this year.
"Although analysts have been rather aggressive in downgrading their 2009 earnings outlooks, they appear to be predicting a sharp recovery in 2010, which seems optimistic given the economic backdrop," said Catherine MacLeod, global macro economist at Fitzwilliam Asset Management.
"Recent moves share many trademarks of a classic bear rally. Volumes have been low, whilst the run up has been particularly sharp -- something that runs against the trend of most sustainable equity recoveries. It is relatively easy to develop a bear case for equities at this juncture."
Another potential source of pressure on stocks from the corporate sector is their still high level of borrowing.
According to Goldman Sachs, corporate pre-tax profits fell to 5 percent of gross domestic product in the first quarter from 5.8 percent in the fourth quarter.
The corporate financing gap -- how much cash a company has to hand after paying dividends -- was in a small surplus of 4.5 cents for every dollar of EBITDA (earnings before interest, taxes, depreciation and amortisation) in the first quarter. That compares with a deficit of around the same amount in the fourth quarter.
But on the liability side, companies' ratio of net debt to EBITDA rose to 3.8 times, surpassing the 3.6 times post-World War Two peak reached in the fourth quarter of 2001.
"U.S. corporates have freed up a lot of cash, mostly by cutting capex and slashing inventories and working capital. But their level of leverage remains very high, particularly with the current uncertainty over the new trend in earnings," Goldman said in a note to clients.
"A deeper adjustment in capital structures is probably in store."
Following the recent decline in equity and commodity prices, Goldman has adopted a neutral risk profile, buying U.S. Treasuries again and moving out of equity trades that played on expectations of U.S. and UK growth.
So the jury is still out on whether markets have just seen a bear market rally or are now entering a new bull market.
An analysis of the past 20 bear markets, cited by Fortis Investments, has found that the average cumulative return after the bottom of a bear market has peaked at 47.1 percent.
This leaves world stocks little room for the upside as they have already rallied 40 percent since mid-March.
Furthermore, the rally has made valuations less attractive.
The price/earnings ratio on the S&P index currently stands at around 16.1 percent, falling just below the long-term average of around 16.2 percent but not the historical bottom of below 10 percent seen in early 1980s. Before the credit crisis in July 2007, the P/E ratio stood at above 27 percent.
"Following their rally, equities are no longer particularly cheap. On the other hand, neither are they expensive. In short, their values are neither a strong sell signal nor a strong buy signal," ING Investment Management said in a note to clients.
"All in all, we are currently in a twilight zone which could last for some time, especially in view of the need for consumers and banks to reduce their debts. In this period, equity markets could fluctuate sharply from current levels, between plus and minus 20 percent."
Reporting by Natsuko Waki; Editing by Ruth Pitchford