While investors are warily watching Europe, another risk for stocks is lurking and it could make October a spooky month.
It's the earnings season, which has been a period of good news during the recovery. However, this quarter may change that because while the numbers should be strong, the company commentary may be cautious to scary.
"If we're pointing toward recession, and that's what the market seems to be telling us—and our economics department keeps raising its risk of recession—then historically, earnings have declined an average of 18 percent heading into recession," said Sam Stovall, chief equity analyst at S&P Capital IQ. S&P Capital IQ is forecasting a 40 percent chance of recession.
"So that means if we think 2011 earnings (for the S&P 500) are $100, we really should be saying maybe that'll be more like $82 (for 2012)," he said. "Of course that 18 percent does not occur all at once. If you apply an average low multiple of 12 times, the implicated low point for this bear market would be 985" for the S&P 500."
Economic conditions have not weakened enough to impact the third quarter, according to Jason Trennert of Strategas Research. Analysts currently expect about a 14 percent increase in profits.
"We are increasingly worried that the guidance that will accompany the coming earnings season will disappoint, especially within the financials and industrials sector ... Estimates for 2012 have indeed started to decline in recent weeks but not nearly enough, in our view, to insulate investors from what could be an especially sloppy earnings season," Trennert wrote.
Company warnings ahead of the third quarter have been much more negative than positive.
As of last Friday, the ratio of negative to positive was 2.63, which is above the 16 year average of 2.3. Eighty-four S&P 500 companies had issued negative warnings as of that time, while 32 had positive comments, according to Thomson Reuters.
Ingersoll Rand joined the negative list Friday, plunging to a two-year low after warning of weaker sales and profits. The industrial company slashed its third quarter profit forecast to a range of $0.77 to $0.80, from $0.85 to $0.95 per share, and said it expects third quarter revenue of $3.9 to $3.95 billion, from a previous $4.05 billion to $4.15 billion. It blamed weak demand in North America for its residential heating and cooling systems and commercial security products.
That contrasts with Honeywell , which last week said its third quarter earnings will likely be at the high end of its forecasted range of $0.96 to $1.01 per share.
Stovall said the earnings news won't necessarily make the fourth quarter a repeat of the third quarter, which saw a 12 percent decline in the S&P 500.
"Whenever, we've been beaten up in the third quarter, we tend to get a bounce in the fourth quarter. Maybe the bar has been set so low - How do you kill yourself jumping out of a basement window?" he said. He also said it may be that companies will not provide the negative guidance expected, and it's possible the economy won't tip into recession.
"It is a disconcerting possibility. A lot of the old rules of thumb are not working any more or you cannot look to them. In particular, an inverted yield curve used to a sign of recession," he said. He said that measure can't be used because of the Fed's Treasury market operation, in which it is selling short duration securities and replacing them with longer duration notes and bonds.
Another recession warning was a 20 percent decline in housing starts but that no longer applies because housing remains depressed. "The only thing we can really point to so far is in the five times since World War II that the year over year percentage change in real GDP has been 2 percent or less ,then we have slipped into recession. Five is not a big number, but five out of five is," he said.
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