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Earnings Season: A Likely Game-Changer—for Good or Bad

Second-quarter earnings could go a long way toward showing whether the much-ballyhooed "green shoots" are real or merely illusions masking deeper economic problems.

Since the recession began, investors have been treating earnings cycles gingerly, hoping that companies can beat severely diminished expectations rather than daring to wish for signs of actual growth.

But that could change in the coming round of reports, which will be watched closely for real signs of a turnaround.

"The negative numbers not being as bad as they were last month is not good enough any more," said Michael Cohn, chief investment strategist at Atlantis Asset Management in New York. "What you want to see is incremental progress instead of decreasing awfulness. That's why the market is stuck."

Getting the market unstuck since its meteoric rise from the March lows has proven a difficult business. The Dowis off about 5.5 percent from its closing high on June 12, which marked the highest the bluechip average had reached since Jan. 6. The index has traded through the same roughly 500-point range since mid-May.

Economic signals have been weighted slightly to the positive side, but not enough to provide clear direction. For every report showing that the manufacturing sector turned in its best performance since last June, there's an unemployment report indicating that the economy continues to hemorrhage jobs.

That leaves corporate America with the unenviable task of proving that a recovery is on the horizon.

"The next major mover in this market is earnings," said Ryan Detrick, analyst at Schaeffer's Investment Research in Cincinnati. "It all comes down to expectations, and expectations have ratcheted up. We had better come in better than expectations."

A surprise to the downside could send the Standard & Poor's 500back down to the low-800s, Detrick said, while a positive beat could push the broad index to 1,000.

As for expectations, the analyst consensus is that profits will be off about 34 percent from the same period in 2008. But while year-over-year comparisons are the most common, those trying to discern improvement in the earnings picture are likely this time around to pay as much attention to quarter-by-quarter results.

The season, in fact, is likely to feature "rapt attention on conference calls with people trying to get a feel on various sectors and subsectors, whether we're seeing a turn, whether it's sustainable, how meaningful it is," said Uri Landesman, head of global growth strategies at ING Investment Management in New York.

Banks will take their fair share of the focus, and the early outlook isn't very positive.

In research released Thursday, Keefer, Bruyette & Woods said it is lowering second-quarter earnings estimates for 109 banks and thrifts by a median of 22 percent while projecting a median year-over-year earnings decline of 52 percent.

Yet Citigroup , among the banks at the center of the credit storm, said its earnings report is "likely to be less of a hurdle for investors" than the first-quarter report because of "an improved financing environment for corporations and a lowering of expectations earlier in the year."

Indeed, many market pros say the season in the broader scope could be as much about outlook than actual results, which are likely to remain somewhat muted given that the recession is at best ebbing.

"It has the potential to be a game changer," Landesman said. "I just think the likelihood is further caution. Most people will say, 'What do I have to gain by going out on a limb? I'm going to stay cautious and let the stock do what it will."

Investors, then, will be left to navigate their way through earnings that are likely to be around expectations and forecasts that will provide hints at what's to come.

"Expectations for the economy definitely have been turning around," Detrick said. "These numbers better prove that."

Portfolio managers are recommending caution.

"Unless you're really trying to make a guess on which way the economy is going, you want to get through this third quarter without anything bad happening," Cohn said. "I'm not in the money-committing mood at this point until that's 50 percent done with."

Cohn expects big-box retailers — Costco , Wal-Mart and Target — to do well but consumer discretionary companies to suffer.

Commodity-driven companies also could gain on a weak-dollar trend, with Cohn specifically mentioning BHP Billiton , Freeport McMoRan and Schlumberger.

"Unless the economy starts to get worse, I think the path of least resistance is up," he said. "The catalyst to go up is going to have to be good news rather than decreasing bad news."

As the earnings churn through, then, there also should ample opportunity to employ the buy-the-dips strategy that has been popular during the stocks downturn.

"By the end of the year, beginning of next year, we'll see real improvement, so I'm going to use the opportunity of what the market delivers to me to take advantage of that," said Michael Kresh, president of M.D. Kresh Financial Services in Islandia, N.Y. "I would love to see the market stay stable, but I expect the market to go up and down and I'm going to buying on the dips. Now is the time to be accumulating, not panicking."