Earnings: Less Than Meets the Eye?

When third-quarter earnings reports start rolling in this week, companies will have a chance to show they're feeling a real economic recovery.

If analysts are right in their predictions—and they've been wrong before—this could be a landmark quarter. In the July-to-September quarter, the financial sector could actually increase earnings for the first time in more than two years. The consumer discretionary sector could show profit growth for the first time in three years.

But that's the good news. Overall, earnings for the Standard & Poor's 500-stock index are expected to fall 24.9% from a year ago, according to Thomson Reuters (TRI).

Banks Still Weak Look more closely at the expected rebounds for financial and consumer profits, and there is less reason to celebrate.

The financial sector's forecasted rebound is almost entirely caused by American International Group (AIG), which reported a loss of almost $10 billion a year ago and could get much closer to breaking even last quarter. With AIG included, financial sector earnings are expected to jump 57%, according to Thomson Reuters. Without AIG, analysts say financial earnings will fall 29%.

Bank results in particular continue to show weakness. Bank specialists at Keefe, Bruyette & Woods (KBW) expect bank earnings to drop 28%, the industry's 11th consecutive quarterly decline.

Alcoa Gets Things Started A similar phenomenon is seen in the consumer discretionary sector, where homebuilders and automakers are rebounding from horrific losses a year ago. Those two industries are entirely responsible for consumer discretionary's expected 17% earnings growth rate. Without them, consumer discretionary earnings would fall 19%, according to Thomson Reuters.

The third-quarter earnings season officially begins on Oct. 7, when aluminum giant Alcoa (AA) reports results.

For investors, the key question may not be the overall level of earnings, but how actual results compare with market expectations. A disappointing quarter could jeopardize stocks' huge gains since March. An outstanding quarter could be more fuel for the market's seven-month rally.

Investors Still Cautious Robert W. Baird chief investment strategist Bruce Bittles worries investors are expecting too much from the third quarter. "In the first two quarters, expectations were in the tank," he says. "Now, we come to the third quarter and people think earnings will be fair, maybe even good."

Others, however, think investors and analysts are still too cautious, giving companies the opportunity to impress them. "Expectations are still pretty low," says Michael Yoshikami, president and chief investment strategist at YCMNET Advisors. "Analysts were significantly burned by the last two years."

Even as the economy has shown signs of improving in the last few months, analyst expectations have remained steady, notes Thomson Reuters global head of research Ashwani Kaul.

Top Line Concerns Kaul says the big question for corporate results is whether companies can begin to increase their sales. After months of layoffs, "Companies have done a good job of containing costs," Kaul says. "They probably can't cut costs anymore," so future growth will need to come from more revenue. Analysts expect S&P 500 revenues to continue falling in the third quarter, by 11%.

John K. Schonberg, manager of the RiverSource Mid Cap Growth Fund (INVPX), says third-quarter earnings could be a repeat of second-quarter results: Revenue—the so-called "top line"— was disappointing, but earnings—the "bottom line" —beat expectations. "Last quarter, that was seen as a good thing," Schonberg says, noting it helped fuel a summertime stock rally. This time, though, investors may be dissatisfied, worrying that weak sales are a sign of a weak economic recovery.

The market reaction may depend on how patient investors are willing to be. Analysts are expecting revenues to begin to rebound strongly in the first quarter of 2010, Kaul notes.

Many Questions Left Open In the meantime, the earnings picture could improve thanks to deep cost-cutting at corporations. "Companies are turning out profits because they're lean right now," says Peter Cardillo, chief market economist at Avalon Partners. "They've laid off a lot of people."

Those profits could help prevent a major correction in the stock market this fall, Cardillo adds.

Third-quarter results could be the first to reflect early signs that the U.S. recession is over. But beyond that, they are likely to leave many questions open. The pace and durability of the recovery is uncertain, for example. It's also not clear which firms and industries will benefit or languish as the economy shifts from a painful recession to a slow recovery.

In the world of the "New Normal," any signs of progress—no matter how small—will be welcome on Wall Street.

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