Market Outlook: Earnings Could Be Next Big Catalyst for Stocks

With the end of the second quarter approaching, analysts think earnings will soon take center stage in the markets again.

Though interest rates and subprime worries have rattled stocks lately, corporate profits will also be closely watched in the coming weeks. And many market pros think that--like the first quarter--the results will come in above unrealistically low forecasts.

"One of the key catalysts for stocks for the first quarter was the fact that estimates were too low," David Dietze, chief investment strategist at Point View Financial Services, told CNBC.com. "If, in fact, Wall Street generally is too pessimistic and earnings come in better than expected again, that would certainly be a bullish factor for the market."

Earnings expectations for the the S&P 500 in the second quarter now stand at 4.4% year-over-year growth, down from the 6.8% forecast at the beginning of the year, according to Thomson Financial. Wall Street also had low expectations for corporate earnings in the first quarter, with estimates dropping as low as 3.3%. Instead, first-quarter earnings ended up 7.8%.

The industrials sector is expected to be the best performer in the second quarter, rising an estimated 14%. Information technology comes in second, with an 8% growth forecast. Consumer discretionary is the only sector expected to show an earnings decline of 8%.

"I think we are going to have somewhat of a repeat because earnings estimates are too low, particularly among large cap stocks leveraged to global growth," said Joseph Quinlan, market strategist at Bank of America. "I think we'll see earnings at 6% to 7%. You are looking at a U.S. economy that rebounded to a degree in the second quarter. We're down from the double-digit numbers, but still running at a solid pace."

"Consistently Underestimates"

"I think Wall Street consistently underestimates the effects of the emerging world on U.S. companies," said Stephen Leeb, research chairman for The Complete Investor. "They focus on relatively slow growth in the U.S. economy when the rest of the world is growing at a rapid pace."

Dietze agrees that second quarter earnings are more likely to fall in the 6%-7% range. "The consumer, for the most part, has held in there," said Dietze. "We still have very strong employment data. We have seen a strong overseas economy, which is robust for us because they buy our goods and services."

Not all analysts are optimistic about the second quarter, however. Some are already seeing signs of trouble on the horizon.

"I'm seeing some trouble, particularly in retail," said Adam Lass, senior market analyst for Wavestrength Options Weekly. "We're starting to see some people come in now and rewrite the whole earnings picture. Specifically, we just heard troubling news from Best Buy and Circuit City and they are sort of the canaries in the coal mine for retail."

"We've only had about 14 or 15 companies reporting (fiscal quarterly results) so far, but what's different is half of those companies have missed numbers," said Douglas Cliggott, chief investment officer at Dover Management. "Eight companies in the last two weeks have missed their earnings expectations. That's very different."

Todd Salamone, director of research at Schaeffer's Investment Research, is concerned that expectations the results will beat forecasts could backfire on the market. "That could be a problem, thinking that we will see a repeat of the first quarter," said Salamone. "That could set the stage for disappointments."

Caution Rules

Guiding with Caution

Onereason analysts' earnings expectations have been lowered is because corporations are delivering conservative forecasts, frequently guiding lower for future quarters.

"Four percent just doesn't ring true to me," Brian Gendreau, investment strategist at ING Investment Management, told CNBC.com. "Management is low-balling it. Many quarters we have seen earnings beat estimates and then you get lowered guidance. After Sarbanes-Oxley, management has every reason to feel compelled not to exceed expectations, but rather to aim low and then beat estimates later."

Bank of America's Quinlan believes companies are forecasting reduced earnings because they are genuinely concerned about the U.S. economy coming out of a soft patch.

"They are worried about how the subprime mortgage situation will affect them, about U.S. protectionism as it is related to China, and they're worried about energy prices," said Quinlan. "There are some legitimate reasons to be more cautious than optimistic and that has proven to be a good strategy."

Investing in a "Myopic" Environment

Earnings reports will begin in full swing the second week of July when Dow component Alcoa kicks off the reporting season on July 9. Until then, analysts expect the markets to waiver back and forth on the news of the day.

"The market and traders seem to have a myopic view," said Michael Barron, CEO of Knott Capital. "They are very focused on the last single data point and extrapolating that to trends in the future. It tells you that there is a very, very short term focus and, to us, that spells added risk."

Next week, the key economic event will be the FOMC interest rate decision, which will be announced on Thursday. Traders will also get the latest existing and new home sales data, as well as durable goods numbers and the final first-quarter GDP.

Companies reporting earnings this week include Walgreen, Oracle, Kroger and Monsanto, as well as homebuilders Lennar and KB Home.

"I think Wall Street is going to start focusing much more on inflation and valuations," said Leeb. "If Wall Street wakes up to the fact that food and energy are in long-term up trends, that will have a definite impact."

"You want to be positioned in sectors that have more clear, predictable earnings streams such as healthcare and consumer stapes," said Barron. He likes MedcoHealth Solutions. "Medco should do well for several years," said Barron. "Pharmacy benefit managers are reaping the benefits of a large number of drugs coming off of patent."

Knott Capital owns Medco.

"We try to look for areas that are undervalued like property and casualty insurance," said Point View's Dietze. "We think investors are overly pessimistic about the upcoming hurricane season and we think property and casualty stocks are oversold." Dietze likes Allstate and owns the stock personally. His clients own it as well.

"Really go through your portfolio and do a housecleaning," advised Lass. "If you are holding gains that are the gift of the previous market, clean house and lose the losers now."

Lass recommends new money go into the oil industry. He recommends the Energy Select Sector Spider (a basket of energy stocks) and Chevron. "It only takes an event in Nigeria to hike the price of oil up to $70 a barrel," said Lass. "There are so many bullets aimed at oil that could move it higher."

Lass does not own shares of either of his recommendations.

Phyllis Burke Goffney is a news editor for CNBC.com. She can be reached at [e-mail].