Earnings: Looking for an Omen

Big losses are expected in financials, but first-quarter earnings in other sectors are a key test of how long the gloom will last

Major League Baseball may have ditched the first week of April as the time to start its season, but the stock market will have its own "Opening Day" on Apr. 7 when Wall Street's traditional leadoff hitter, Alcoa (AA), releases first-quarter results. Alas, the players posting results for the period may have a poor batting average: Investors should expect a big drop in profits for U.S. companies in the first quarter, thanks to the credit crunch and a slowing economy.

But even if the overall mood is certain to be gloomy, unexpected signs of strength could raise hopes for a strong profit rebound later this year.

"Analysts are slashing" their profit estimates as the quarter comes to a close, says Ashwani Kaul, senior research analyst at Reuters Estimates (RTRSY). It's common for pessimism to rise toward the end of the quarter, Kaul adds.

Reuters Estimates expects earnings for companies on the S&P 500-stock index for the three months ended Mar. 31 to fall 5.5% from a year ago, with losses in the financial sector swamping many of the small gains in other sectors. Excluding financials, corporate profits would rise more than 8%, Kaul says. Thomson Financial, which uses a different method of compiling analyst estimates, expects S&P 500 earnings to fall 8.1% this quarter.

Analysts seem to expect a repeat of the very disappointing fourth-quarter earnings season, when total S&P 500 earnings fell 20.4% but financial sector earnings were nearly wiped out, plunging 94%.

More eye-popping losses are expected from the big banks and financial firms, with most writedowns attributed to the subprime mortgage crisis and other credit woes.

Looking to Industrials, Technology, and Telecom

Recent earnings reports from other investment banks that report with a November fiscal year-end were bad, but not as bad as investors expected. Goldman Sachs (GS), Morgan Stanley (MS), and Lehman Brothers (LEH) report on a different quarterly schedule than most companies. That raises hopes that earnings for other financial firms may not deteriorate quite as much as they did in the fourth quarter, says David Dropsey, an analyst at Thomson Financial.

But all the focus on financial sector earnings might be distracting investors from important events in the rest of the market.

Stocks in other sectors—like consumer discretionary, industrials, technology, telecom, and basic materials—face a key test this earnings season: How much is the slowdown in the economy affecting corporate bottom lines?

Many economists believe the economy started to slow significantly in December, so this will be the first quarter to fully reflect the economic downshift.

Information technology stocks have been punished since the New Year, as analysts lowered estimates for profit growth from about 14% at the start of the quarter to 9% now, according to Thomson Financial. That adjustment to the new economic reality "seems a bit overblown," Dropsey says, because tech firms may be able to beat those low expectations with strong revenue for overseas.

A key early test, according to Dropsey: The earnings report from Oracle (ORCL) released after the close of trading on Mar. 26. The software giant seemed to fail that test, however. New software sales at Oracle were up 16% but that was at the low end of investors' expectations.

Recession or Revival?

The question uppermost in the market's mind is whether the U.S. economy is facing a long recession or a brief economic slowdown. First-quarter earnings reports could begin to answer that question.

Looking at late 2007 earnings reports, it's clear "there is a recession," says Gary Wolfer, chief economist at Univest's Wealth Management & Trust Group (UVSP), "but it's contained to only two sectors of the S&P 500," financials and consumer discretionary, which includes the homebuilders. "As long as it's contained there, we have a much easier chance to rebound," Wolfer says. If other sectors continue to do well, investors may let go of some of their worst recession fears.

Reuters Estimates expects earnings to rise 29% in energy, 12% in technology, and 7% in health care.

Most analysts are predicting a big revival in earnings in the third and fourth quarters of 2008. By then, investors hope the credit crunch is over and the economy should be coming out of its funk. Earnings for financial firms are expected to jump from the year before, when banks posted billions of subprime losses.

If analysts' predictions hold up, S&P 500 earnings could rise a solid 18.6% in the third quarter and a big 65.3% in the fourth quarter.

For those predictions to come true, the U.S. will need to avoid a deep recession and the credit crunch must end by midyear. Unfortunately, neither is a certainty. For now, investors will have to wait for the final score of Wall Street's annual "Spring Classic."

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