Financials Overshadowing Strong Earnings Season

Excluding the beaten-down financial sector, fourth-quarter earnings have been pretty solid so far.

Unfortunately, the stock market isn't paying much attention. 

Over halfway through the earnings season, corporate profits are up a healthy 11.8% if you leave out the banks and brokerages. But if you include that sector, profits are down a worse-than-expected 20.1%, according to Thomson Financial.

"They’re not as horrific as they feel," says Tony Dwyer, a market strategist at FTN Midwest Securities.

The shadow cast by financials, and the rather timid earnings forecasts from many companies, have sent stocks plummeting since the beginning of the year, with many market pros forecasting a recession.

"The problem is the guidance has been bad," Dwyer says. "It’s the feeling that poor earnings are going to continue."

As of Tuesday, 314 companies in the S&P 500 had already reported their results. Of those, 61 percent had outpaced analysts' estimates, 13 percent matched estimates and 26 percent have fallen short, according to Thomson.

Both the technology and the energy sectors have shown the strongest gains. Together, these sectors have contributed some 40 percent to earnings growth, according to Michael Thompson, director of research at Thomson Financial.

Beyond the Balance Sheet

Although Thompson expects to see some of the weakness continue over the next few quarters, he is not surprised by the conservative earnings forecasts coming from the companies.

"Companies are being a little guarded," Thompson said. "But they are guarded in bull markets. They like to under-promise and over-deliver."

The weak fourth-quarter results are expected to contribute to a 3.7 percent decline in corporate earnings from 2006 to 2007, said Howard Silverblatt, senior index analyst at Standard & Poor’s. However, profits should rise 17.2 percent this year.

Fortunes Hinge on Financials

But fortunes can swing wildly if the financial sector takes another hit, according to Silverblatt. He noted that only six months ago, 2007 earnings were estimated to rise 7.7 percent from the prior year.

"We definitely have to get past the writedowns in the financial sector," said Jeffrey Kleintop, chief market strategist for LPL Financial Services. "We've seen the bond insurers move the market because investors are trying to see what that means for financials and whether they are going to have to take additional hits."

Still, with the bulk of the sectors outside of the financials posting double-digit earnings growth rates, not all stocks should succumb to the weakness in the financial sector, Kleintop said.

Following the latest reports, analysts have reduced very few estimates for industrial, healthcare, technology and staples companies, according to Kleintop.

Earnings Season Bright Spots

“That’s good news,” he said. Kleintop expects to investors rotate back into large-capitalization growth stocks.

But Dwyer expects investors will continue to react to fears about the health of the economy in the near term.

He expects many investors are looking for signs of a recession and will react to economic data such as Tuesday's report from the Institute of Supply Management, which showed the U.S. services sector retrenched more sharply in January than many were expecting.

At the moment, Dwyer recommends investors buy stocks of companies in the information technology sector, where he thinks the stock price weakness is "getting overdone," as well as those in the healthcare sector.

Stockpiles of Cash

Although investors are still debating whether the U.S. economy is in the midst of a recession or merely an economic slowdown, there is evidence to show that Corporate America has a hefty stockpile of cash to weather an economic downturn.

According to Silverblatt, the non-financial companies in the Standard & Poor’s 500 Index have $613 billion in cash on their books.

"That's 65 weeks of net income," Silverblatt said. "That should be enough of a war chest to ride through a mild recession."

According to analysts estimates, earnings growth is expected to rebound in the second half of this year. Although part of this is due to the fact that many companies will be facing easier comparisons with last year's results, there are other factors at play.

For example, Silverblatt said if Congress passes the proposed economic stimulus package, consumers will likely begin to receive these tax rebates and begin spending this money in time to help third-quarter results. The timing of the economic stimulus money may also coincide with the receipt of income tax refunds and the follow-on benefits of the Federal Reserve's recent interest rate cuts as well, he said.

Christina Cheddar Berk is a News Editor at CNBC.com. She can reached at christina.cheddar-berk@nbcuni.com.