Earnings May Spook the Street

Disappointing early reports on third-quarter results from Monsanto, Alcoa, and others may test the stock market's recent rally

Expectations are low, and falling, for U.S. companies in this third-quarter earnings season, a key test for the recent stock market rally.

Analysts were already expecting the lowest growth in corporate earnings in years. But in the first earnings reports of the season, several large companies, including Monsanto (MON) and Alcoa (AA), have missed expectations. And several more, including International Paper (IP) and energy outfits Chevron (CVX) and Valero Energy (VLO), have warned of lower profits in forthcoming reports.

True, there are early bright spots, too. Costco (COST) shares hit an all-time high on Oct. 10 after a good profit report that showed same-store sales up 5%. And it's still very early, with hundreds of companies still set to report earnings from the July-through-September quarter.

Analysts' Expectations: Too Downbeat?

Even so, the earnings season hasn't made a good first impression. Reuters Estimates tracks analysts' estimates as well as quarterly earnings as they're being reported for companies on the broad Standard & Poor's 500-stock index. At the beginning of the week, earnings were expected to rise 3.2% year-over-year. By midweek, that number was 2.6%.

"We're not really expecting a blockbuster quarter," says Ashwani Kaul, an analyst at Reuters Estimates. In the first two quarters of 2007, earnings growth for the S"P 500 was over 8%, down from double-digit gains in 2006.

This quarter, strength from health-care and technology companies is expected to be outweighed by flat or lower earnings in many other sectors. Cyclical consumer stocks were expected to fare the worst.

It would surprise no one if overall earnings came in much stronger than analysts were expecting. For more than three years, corporations have routinely beaten analysts' expectations. According to a note from Deutsche Bank's (DB) U.S. equity strategy team, earnings growth has exceeded expectations by an average of four percentage points since 2004. "We see the risks to earnings as once again being to the upside," they wrote.

But some think investors are expecting too much from earnings reports this quarter.

Alcoa's Revenues Fall

Chris Johnson of the Johnson Research Group believes "investors are still drunk" on the happy effects of the Federal Reserve's large interest rate cut last month. The rally is being driven more by "a fear of being left behind than a desire to invest in quality." All that buying momentum could turn into selling pressure quickly if earnings continue to be disappointing, he says.

Alcoa, traditionally the first major U.S. public company each quarter to report earnings, saw revenue fall 3.2%, and earnings per share of 55 cents missed expectations by 11 cents. On Oct. 10, the share price was down 99 cents, or 2.49%, to close at $38.73 per share.

Pat Dorsey, stock analyst at Morningstar (MORN), says many U.S. companies are benefiting from a weak U.S. dollar, which increases profits from abroad. Alcoa, as a large aluminum company, is the opposite: It is hurt by the high dollar because it tends to produce abroad and sell to U.S. companies.

"Earnings reports this quarter are going to be very muddied by the currency issue," Dorsey says. He adds it's important to look behind the one-time currency issue to get a sense of how a company's really doing.

Monsanto's 39-cent-per-share loss, or an 18-cent loss excluding one-time items, missed analysts' 17-cent projection. The agricultural science firm can boast of exceptional growth prospects, but the stock is already valued on the expectation of strong growth for years. The stock opened down 2.8% on Oct. 10 but recovered much of its losses by the end of the trading session. It ended the session down 0.83%, or 74 cents, at $88.78.

Fourth-Quarter Guidance: Key

What's on everyone's mind right now is how much the U.S. economy is slowing down. That includes questions about the mood of American consumers, the state of the housing market, and the effects of credit and mortgage issues.

For this reason, companies' guidance for the fourth quarter and for 2008 may matter far more than the third-quarter earnings numbers, Dorsey says.

Investors already may be looking past soft third-quarter earnings and preparing for better times ahead. According to Reuters Estimates, analysts are expecting S&P 500 companies to return to double-digit profit growth in the fourth quarter and early next year. In coming weeks, the markets could be spooked by any signs those larger profits aren't on the way.

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