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Optimism to be tested as firms set next moves ; Expansion may follow profits from cost cuts

As concern about the economy eases, investors are increasingly optimistic about stocks and have pushed the market up by more than 100 percent from the lows of early 2009.

But the next few weeks could test whether continued optimism is warranted.

As companies report their profits for 2010 and CEOs provide outlooks for the months ahead, Standard & Poor's analyst Howard Silverblatt said, "I'm going to be looking for signs that they will be building and making more products and hiring new people."

In the last couple of years, companies have produced substantial profit gains, compared with deeply depressed levels during the recession, by delaying maintenance and purchases, plus slashing payrolls. Those profits have been encouraging to investors. Yet profits are below 2006's pre-crisis peak, and companies eventually will have to invest in their businesses and bolster sales if the momentum is to continue.

"I find it hard to believe companies can produce any more major savings after cutting so diligently," Silverblatt said.

Analysts are predicting that profits will reach a record in 2011, with earnings per share at $94 or $96, compared with 2006's $87.72 and the $49.51 at the depth of the recession in 2008. Silverblatt estimates that sales would have to climb by almost 13 percent in 2011 to produce the $94 Standard & Poor's analysts are expecting. Currently, however, analysts estimate about 9 percent.

While sales have appeared strong compared with recent quarters, they have yet to match pre-crisis levels. Sales for the last 12 months are estimated at $8.7 trillion, still trailing 2008's $9.1 trillion, Silverblatt said. During the recession, sales plunged by about 40 percent.

Still, many analysts, including Silverblatt, think that 2011 could be the year of recovery. Goldman Sachs, for example, is estimating that the Standard & Poor's 500 will end 2011 at 1,500, compared with Tuesday's close of 1,295, as sales increase and earnings reach a new high of $96 per share.

Analysts have been encouraged by recent economic data pointing to improvements in manufacturing, retail sales and employment, although payroll increases remain weak.

In addition, Goldman Sachs strategist David Kostin said, prospects improved when Congress and the White House cut taxes for a year and extended unemployment benefits and Bush-era tax cuts. With that extra stimulus, Goldman economists upped their GDP growth forecast by 0.7 percentage points, to 3.4 percent, in 2011.

In a survey of fund managers throughout the world, Merrill Lynch said last week that growth expectations have climbed strongly since last summer and that "fears of a double-dip recession have vanished."

Yet, despite the recovery in the economy, some strategists are skeptical about whether companies can produce the growth that is needed to justify climbing stock prices. As companies report their 2010 earnings, analysts are expecting profits to be up by an extraordinary 47 percent over the previous year's figures.

But gains such as those are relatively easy to achieve when the comparison is against a depressed year such as 2009. In the quarters ahead, when companies report sales and earnings, the results will be compared with stronger 2010 periods, making it more difficult to show a comparatively strong boost and excite investors.

Also, costs of energy and basic materials have been rising, so companies are expected to face higher costs without being able to pass them on to consumers. That could put pressure on profit margins. As American consumers continue to struggle with high unemployment, little wage growth and persistent debt, companies are not expected to have much ability to raise prices.

Morgan Stanley strategist Adam Parker recently said in a note to clients that analysts have been extrapolating growth expectations from those of the recent past, but "companies cannot maintain the recent pace of improvement indefinitely." He notes that as margin improvements lag behind expectations, investors could be disappointed in mid-2011.

Disappointments can lead to stock market corrections or declines in prices. So in the next few weeks, it's important to listen closely to earnings reports.

Citigroup strategist Tobias Levkovich said that "several companies already have begun to hint" of slowing growth. Despite the risk of disappointing investors, however, he thinks that the "stock market should be able to post respectable appreciation in 2011."