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Ready for an Earnings Slowdown?

Call it the last hurrah. Companies in the S&P 500 index should report a double-digit gain in first-quarter profits, according to S&P analyst estimates, but won't repeat that strength for the second quarter. First-quarter operating profits are expected to rise 11.3% year-over-year, marking the 16th consecutive quarter, or four full years of double-digit growth. Second quarter operating earnings are projected to increase 7.4%, breaking the string and stopping the record.

The only true surprise is how long earnings maintained their growth. While option expensing is partly to blame for the earnings slowdown, consumer spending appears to be the primary culprit. To some degree, consumers are what kept profits going for so long. Tax time for the payers (with no significant credits this year), higher winter heating costs (despite a warmer January and a 9% drop in use, expenditures for January and February were up 45%), and high gas prices would all appear to us to put a short-term hold on spending.

ENERGY DRAIN. S&P economists predict that consumer spending in the second quarter will slow to 2.9%, from the first quarter's 5.3% pace. However, we at S&P still believe in the American consumer's ability to charge on. So we expect the double-digit earnings gains to return in the third and fourth quarters, coinciding with the return of consumer spending.

Another reason for the second-quarter drop-off in growth is that energy sector earnings are expected to slow, posting a year-over-year gain of 14.3%. Usually, 14.3% is an impressive gain, but for energy it comes after a 54.1% jump for the fourth quarter of 2005 and an expected 45.1% rise for the first quarter.

OIL SPIKE?However, if energy-sector profits for the second quarter of 2006 were to come in 3% ahead of the fourth quarter of 2005, the 7.4% earnings gain for the S&P 500 would become 10%. That's not likely if oil stays in the $66 a barrel range. But if oil goes up for reasons such as Iran pulling back due to U.N. actions, natural events, or terrorism threats, it's feasible.

Given energy companies' ability to swiftly pass along higher costs (due to regulations established in the 1970s), a prolonged spike in oil could boost energy sector profits high enough. Specifically, oil would need to average in the very high $70s for half the quarter. The important thing to note, though, is that doesn't count any reduced consumption or the additional impact on non-energy earnings.

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