Quarterly Profits to Show Smallest Gain in Five Years

Third-quarter corporate earnings are expected to show the weakest growth in five years, but a rebound is likely in the fourth quarter, according to the latest estimates.

The current credit crunch, which began in mid-summer, is having a predictable impact on the financial services sector, which makes up about 28% of the earnings in the Standard & Poor's 500 Index. That soft spot is skewing the outlook for the nation's largest companies.

"You cannot have a good quarter without the financials," said Howard Silverblatt, senior index analyst at Standard & Poor's.

For now, Thomson Financial is predicting earnings growth of 4.4% in the third quarter before rebounding to double digits in the fourth. S&P is slightly less optimistic, expecting profits to rise about 2.1% in the third quarter and 10.8% in the fourth.

Still, as in past quarters, the forecasts may prove to be more pessimistic than the actual results. That's because many companies--and analysts--lowball their estimates so that the real numbers appear to beat expectations, usually boosting the stock.

Companies are expected to start reporting results for the third quarter, which ends Sunday, in the next few weeks.

The financial services sector has been rocked by turmoil in the credit markets, and will likely post weak profit. Revenue from mortgages and refinancing has shrunk, hurt by a soft housing market, rising default rates, and a liquidity crunch. Liquidity pressures also caused losses in fixed-income investments and dealt a body blow to merger and acquisition activity.

The latest earnings from the major brokerages provided a glimpse of what may be to come for the group this earnings season. The reports turned up a mixed bag, with Bear Stearns falling far short of analyst expectations, while Goldman Sachs Group played its cards right and profited.

In the wake of the brokerage reports, Wall Street analysts have not made major revisions to their third-quarter earnings forecasts for the financial services sector, according to John Butters, director of earnings research at Thomson Financial. However, earnings forecasts for the large banks are all over the map.

“The vast majority of the fallout is in a limited number of companies,” James Paulsen, chief investment strategist at Wells Capital Management. “To them, it’s devastating.”

“I think home builders will have horrible earnings,” he said. “I think there are some mortgage providers that will have horrible earnings.”

CONTINUED : A 'huge dichotomy of performance'

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