Fourth-Quarter Earnings: How Bad?

With the change in the calendar, companies are busily compiling their end-of-year financial reports, and the truth is that no one is really sure what they will say.

Last fall's financial crisis and steep downturn scrambled the expectations of analysts and investors. Weak third-quarter results left many executives unwilling to predict how the fourth-quarter holiday season or 2009 would play out. Economic data heighten fears of a deep slowdown, but economists disagree on how bad conditions will get or when a recovery begins.

Analysts have made their guesses, however. According to Thomson Reuters (TRI), earnings for companies in the broad S&P 500 index are expected to decline 1.2% in the fourth quarter of 2008.

That might seem like a minor decline amid so much economic carnage and financial turmoil. But consider that at the beginning of the fourth quarter, earnings were expected to rise 46.7% from a year ago.

Profits in the Financial Sector

The only reason earnings remain close to breaking even now is that the financial sector is expected to manage a small profit after huge losses at the end of 2007. "Financials are actually going to help earnings," says Ashwani Kaul, Thomson Reuters director of research.

Outside of financials, there is plenty of economic pain in analyst forecasts. Consumer discretionary firms' earnings are expected to fall 54%, reflecting the weak holiday season and a slowdown in consumer spending. Energy earnings should fall 17%, Thomson Reuters says, while industrials are slated to drop 18%, the materials sector to fall 66%, technology should be off 15%, and telecom should drop 14%.

Sectors like consumer staples, health care, and utilities should see single-digit profit increases if analysts are correct.

But will the Street seers get it right this time? Conversations with professional investors and market strategists reveal a lot of skepticism.

"Nobody really believes 'company X' is going to earn what the consensus forecast is," says John Buckingham, chief investment officer at Al Frank Asset Management. He believes analysts are still too optimistic.

Earnings reports from Goldman Sachs (GS) and Best Buy (BBY) in mid-December might have been harbingers of how the market will react to earnings reports. Although both the investment bank and consumer electronics retailer reported mixed results, the market reacted by sending their stocks rocketing higher by double-digit percentages.

Bad News Already Factored In?

At least in these sectors—hard-hit by the economic crisis and stock market sell-off—dismal expectations might already be reflected in the stock price, says Doug Roman, managing director and senior vice-president of PNC Capital Advisors (PNC). By merely beating the "worst case" scenario, Best Buy and Goldman actually impressed investors.

Expectations are very low for fourth-quarter earnings season, says Richard Sparks of Schaeffer's Investment Research. "Even terrible news, if it's not as bad as expected, might be seen as a positive," he says.

The traditional start of earnings season is the release of Alcoa's (AA) report, scheduled for Jan. 12. It's the first major company with a fiscal year ending Dec. 31 to report results.

Before that, companies with fiscal years ending in November continue to unveil results. Monsanto (MON), Bed Bath & Beyond (BBBY), and Family Dollar Stores (FDO) earnings are due on Jan. 7.

Bruce Bittles, chief investment strategist at Robert W. Baird, believes "earnings will be significantly under pressure for the next two quarters."

"Investors are expecting the worst in terms of the economy and earnings," Bittles adds. But, the stock market may begin to look ahead to an expected recovery in the second half of the year.

Fuzzy Math

With the market in turmoil and an economy in crisis, looking ahead will be especially difficult.

"This is a very difficult time because the normal metrics you usually rely on don't work," Buckingham says.

Indeed, the market's preferred signpost of stock valuations may be harder to read this time around. Earnings are important to investors as a reflection of a company's fundamental value, with many relying on the price-earnings ratio as a basic measure of a stock price's reasonableness. With few market participants sure where earnings are headed, calculating those p-e ratios has become an exercise in fuzzy math.

When earnings season begins, investors will be listening to executives' commentary very carefully for insight into future earnings trends, Sparks says. In the last quarter, many execs seemed befuddled by the changing environment, and many refused to predict future results.

That spooked the market, Sparks says. "That lack of news worries the market more than bad news," he says.

If investors get their wish, earnings seasons will give investors a bit more confidence in the future — even if that future is rather bleak and depressing.

But the stock market's recent rally could be stopped in its tracks by the opposite outcome. Yearend results could be as bad or even worse than feared, but investors could get no more insight into how long the economic pain will last. And as the old saw goes, there's nothing Wall Street hates more than uncertainty.

Before it's here, it's on the Bloomberg Terminal.