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Corporate profit outlook is weak and getting weaker

Adam Jeffery | CNBC

Corporate profits are tracking at about a third of original expectations and trending lower, setting up a potentially rough ride when reporting season begins next week.

Earnings for companies on the S&P 500 stock index are expected to grow just 3.5 percent on a quarterly basis, a number that on its face appears consistent with trends but is well below the lofty projections set earlier this year.

So while the stock market obsesses over the debt drama in Washington, a bigger concern could be the dimming prospects for corporate balance sheets.

Not only have earnings per share estimates dropped, but companies and analysts also are taking an increasingly pessimistic view of profits, with negative revisions in the past two quarters at their highest levels in more than a decade.

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"As we approach third quarter earnings season, the ratio of negative-to-positive guidance remains elevated, despite being lower than last quarter, as companies continue to reduce analyst expectations," Adam Parker, managing director at Morgan Stanley, said in a note to clients. "We would be surprised to see a rash of negative pre-releases next week. Nonetheless, estimates have further to fall."

The revisions scorecard so far looks pretty ominous.

Some 104 companies in the S&P 500 have reported guidance, with 65 negative, 23 positive and 16 in line with analyst expectations, according to S&P Capital IQ. That 2.9-to-1 ratio of negative surprises is above the 10-year average. The first third-quarter results to trickle in show 59 percent of the 17 companies beating estimates.

As for revenue, the picture is slightly better.

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Top-line growth for the stock market index is expected to be 4.8 percent after barely rising in the second quarter.

In sectors, S&P Capital IQ projects telecom to be the biggest gainer in EPS at 26.2 percent, while financials should lag with a drop of 2.7 percent. Consumer discretionary is expected to post a 20.6 percent revenue gain, while telecom, despite its big profit boost, is projected to show a revenue decline of 10.4 percent.

This will mark the first quarter that Alcoa will not constitute the traditional kickoff of earnings season. No longer a Dow component, Alcoa will make way for JPMorgan Chase to get things started Oct. 11.

"Common headwinds include a pickup in interest rates during the second half of the quarter, a resulting strengthening in the value of the U.S. dollar, an increase in oil prices following the flare up of tensions with Syria, as well as a weaker-than-expected increase in (second-quarter gross domestic product) as a result of the unresolved sequestration," Sam Stovall, S&P Capital IQ's chief equity strategist, said in a report.

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At the beginning of the year, analysts expected third-quarter earnings to grow 9.84 percent. The story was similar for the second quarter, when 8.9 percent EPS growth projections on Jan. 2 far outstripped the 4.87 percent reality.

Of course, the market has paid the lackluster earnings little attention.

At a time when full-year earnings growth is projected to be 6 percent, the S&P 500 has soared more than 18 percent. Investors have focused far more on whether the Federal Reserve is keeping the cheap-money spigot open than whether profits are keeping pace.

—By CNBC's Jeff Cox. Follow him @JeffCoxCNBCcom on Twitter.

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