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Profit Outlook Grows Even Grimmer For Third Quarter

As earnings season kicks off Tuesday with Alcoa's results, analysts have been lowering their already bearish forecasts for the third quarter.

The result: corporate earnings are expected to be the weakest in five years and could actually show an overall decline.

The grimmest outlook, as expected, is in the financial services sector following profit warnings by Citigroup, UBS,Washington Mutual and Merrill Lynch.

Still, while analysts predict a brutal third quarter, they believe earnings will rebound in the fourth quarter. And many market watchers continue to predict that even third-quarter results won't be as bad as forecast, leading to some "upside surprises."

The picture will become more clear as the market digests the first wave of third-quarter reports this week. On Tuesday, Alcoawill be the first of the Dow 30 companies to release its results. The aluminum producer, which announced last week that it will take a charge ahead of the sale of some business units, is expected to post a modest increase in profit.

General Electric, another Dow component and the parent of CNBC and CNBC.com, will report its results on Friday. Others on this week's calendar include Costco Wholesale on Wednesday andPepsiCoon Thursday.

The recent upheaval in the financial markets, which marked by a lack of liquidity in the credit markets this 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.

Thomson Financial is predicting earnings growth of 0.8% in the third quarter before rebounding to double digits in the fourth. However, the forecast could turn negative as financial services analysts are still in the process of lowering their quarterly estimates, according to John Butters, director of earnings research at Thomson Financial.

S&P is even less optimistic, expecting profits to decline about 1.6% in the third quarter before swinging back to a profit of more than 10.8% in the fourth quarter.

But, as in past quarters, the estimates could prove too pessimistic.

"I think the estimate for this quarter...is probably too low," said David Spika, vice president and investment strategist of WHG Funds, in an interview on CNBC's "Power Lunch." "The fear of what was going to happen in the financial sector, I think, caused analysts to ratchet down their estimates too far."

Spika expects to see good earnings out of the energy and technology sectors as well as some of the basic materials companies and others in industries exposed to foreign growth.

"I think we’re going to see earnings surprises to the upside - not double-digit levels - but to the upside, and I think the market’s going to be pleased," Spika said.

Large Losses on Loans

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.

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Investors have already seen a mixed bag of results from the major brokerages such as Bear Stearns, which fell far short of analyst expectations, and Goldman Sachs Group, which played its cards right and profited. And there has been a hint of what's to come as Citigroup, UBS, Washington Mutual and Merrill Lynch said they would all record loan-related losses in the third quarter. Wall Street has largely taken these announcements in stride, and some bullish investors think that the banks will be overly cautious with this quarter's charges, so much so that there could be reversals of these items in futures periods.

“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.”

Investors will be paying close attention to several bellwether companies in the lending sector to gauge the extent of the lending crisis. Among them are student lender SLM Corp., which is more commonly known as Sallie Mae, and M&T Bank, which is one of the first regional banks to release its third-quarter results.

A 'huge dichotomy of performance'

Considering the impact the financial sector is having on the overall outlook for the quarter, it is worth mentioning that other sectors could turn in strong results.

“We’ve had a huge dichotomy of performance,” Paulsen said. He said, the market’s sentiment is based largely on the performance of this one small piece of the economy, but “there are many, many parts of the economy that haven’t been impacted by this crisis.”

3Q07 S&P 500 Scorecard

Sector
Growth
Consumer Discretionary -7%
Consumer Staples 3%
Energy -4%
Financial -6%
Health Care 12%
Industrials 9%
Materials 1%
Technology 10%
Telecom 4%
Utilities 2%
TOTAL 0.8%
source: Thomson Financial

“It’s easy to forget, but we had pretty good momentum coming into the quarter,” he said.

One area where he expects to see some earnings surprises is in the industrials and basics segments. Paulsen said he expects these companies may benefit from improvements in trade.

Tech, Health Care To Shine

There also are widespread expectations that the technology and healthcare sectors will turn in strongest performances this earnings season.

The tech sector is expected to return to double-digit earnings growth in the third quarter, according to S&P's Silverblatt.

“Companies are in a lot better shape than consumers,” Silverblatt said. “They have cash to spend. Much of technology earnings comes from business. They also have international sales.”

According to Andrew Schroepfer, a managing partner at Exponential Capital, the strength in the tech sector is fairly broad.

“You look at Nokia selling record numbers of handsets. You look at Appleselling record numbers of handsets for a brand new device,” Schroepfer said, during an interview on CNBC’s “Squawk Box.” “You can go right down the list…Across the board you see strength.”

On the flip side, the energy and consumer discretionary sectors, which include homebuilders such as KB Homes and automakers such as General Motorsare expected to post weak results.

At the moment, energy earnings are expected to decline, but much of that has to do with the very difficult comparisons energy companies are facing in the year-ago period, when energy earnings rose 34%, according to Silverblatt.

Retailer Warnings

Retailers may disappoint, according to Paulsen. This was certainly the case for Target and Lowe’s, which both recently warned that sales have been soft.

Discount retailer Target trimmed its September sales forecast to a range of 1.5% to 2.5% sales growth, down from a prior range of 4% to 6%.

Meanwhile, home improvement retailer Lowe’s expects the weakness in sales to pressure the company’s earnings estimates for the year. The Mooresville, N.C., now expects earnings for its fiscal year ending Feb. 1 to be at the low end of an earlier forecast of $1.97 to $2.01 a share.

The warnings from these retailers raised fresh concerns about the health of the consumer, who so far has continued to spend even in the face of rising economic concerns, falling home values, and a turbulent credit market.

No doubt, investors will be looking for fresh clues in the third-quarter results about how Corporate America will fare.

Expectations are high for a strong finish to the year. Still, investors may have already priced in disappointing earnings news since many S&P 500 stocks are trading at a lower price-to-earnings multiple than has historically been the case, according to Silverblatt.

Another wildcard will be the impact of foreign exchange. The record weakness in the dollar likely came too late in the quarter to be a big boost for third-quarter profits, but it could be factor in fourth-quarter outlooks.

Investors need remember that the S&P 500, makes just over half its profits outside the U.S.

"Overall, you're looking at a fairly flat to basically zero earnings growth quarter-to-quarter, but there are some sectors that are going to provide some positive growth, so you have to be in the right spot at the right time," said Darin Richards, chief investment officer at AKT Wealth Advisors, during an interview on CNBC's "Power Lunch."

Christina Cheddar Berk is a news editor at CNBC. She can be reached at christina.cheddar-berk@nbcuni.com.