Third-quarter earnings season likely will indicate continued recuperation for corporate America, but for the stock market the focus will remain elsewhere.
Even with projections scaled back somewhat, companies in the Standard & Poor's 500 are still likely to post earnings growth of about 24 percent—hardly the roaring numbers of recent quarters but still impressive.
What will be harder is how to grow a market so focused on economic growth and the Federal Reserve's policy plans, beyond what individual companies have to say about past results and future hopes.
"Expectations are going to be subdued," says Brian Gendreau, market strategist with Financial Network, based in El Segundo, Calif. "When companies beat, it won't be by as much. Even when we have had earnings beat by a huge amount, the market doesn't always react. It punishes those that miss estimates severely."
With ever-increasing correlation in movements up or down among S&P components, getting a big move from earnings has become increasingly difficult.
The market rallied in July at the beginning of second-quarter earnings season but gave the profits back in August. In the first-quarter, stocks ignored April's solid earnings run and instead focused on sovereign debt issues and pushed the market lower.
"The market has become much more macro-oriented," Gendreau adds. "Stocks pickers have been having a harder time making money by individual stock-picking. That probably continues through earnings season and dampens the market reaction to surprises."
The biggest exposure, in fact, could be to the downside.
Though the rally has run out of steam in the past four trading sessions, this month has proved shockingly strong. This is shaping up to be the market's best September since 1939.
But such a rally will be hard to sustain. As much as the market may be simply clawing back the losses it suffered in August amid double-dip economic fears, it also may be pricing in a decent earnings season. Any disappointments, then, would be felt sharply.
"There's a great possibility of buy-on-the-rumor sell-on-the-news, as in earnings seasons past. This may well be one of them, where even if you beat it doesn't help very much," says Art Hogan, managing director of Jefferies in Boston. "In terms of coming into an earnings cycle, it's difficult to see the ramp-up in prices and not think that it can't last forever."
The good news for stock market bulls is that most of the big market analysts are predicting a solid earnings season, even if it's not quite as robust as its predecessors.
But the third quarter will not have the luxury of easy comps—the previous year's quarter—and thus will have a higher bar to cross to convince investors that corporate America is back.
"This particular earnings season will be the test case for whether or not deceleration in growth continues to impact guidance and actually impacts revenue growth," says Quincy Krosby, strategist at Prudential Financial in Newark, N.J.
"The comparisons are getting more difficult now," she adds. "You see a continuation of what we saw last quarter in the dichotomy between those companies who have overseas markets vs. those that are dependent solely on US markets."
While the Oct. 7 report from Alcoa will be regarded as the official kick-off for this year's earnings season, a handful of S&P 500 companies have reported already. Fourteen of the 17 companies reporting have beaten expectations, perhaps setting the stage for a strong round.
"Negative preannouncements have been limited so far, and despite a significant slowing in US GDP growth some macro headwinds to EPS have abated," analysts from Bank of America Merrill Lynch said in a research note. "As long as the economy is not in a recession, we consider that companies tend to beat analyst estimates for the quarter."
Indeed, Wall Street will be hoping that historical trends hold, with both earnings season and a critical mid-term election looming.
JPMorgan analysts point out that stocks on average rise 5 percent from now until the end of the year during midterm elections, which have coincided with stock gains 21 of the past 28 times.
Standard & Poor's chief investment strategist Sam Stovall is seeing "above-market increases" in three of the 500's 10 sectors while "no sector is projected to post year-over-year earnings declines."
And Goldman Sachs is predicting full-year after-provision S&P 500 earnings of $81 per share—hardly robust but at least in line with consensus. Credit Suisse is matching the Goldman projection, but is more pessimistic about the future with an $82 EPS projection for 2011.
"We believe the slope of the earnings profile of S&P 500 companies is changing in an abrupt fashion—from a vertical incline to essentially a flat line," Credit Suisse said in a note to clients earlier in the month. "One reason is the observed changes in leading indicators of US economic growth and S&P 500 operating earnings."
As such, Hogan says that while outlooks always generate a great deal of attention, he'll be looking especially not just for what companies say about the quarter ahead, but particularly 2011.
Political changes likely to happen in the November electionshould help answer a swath of questions about taxation and regulation that will determine what earnings profiles look like in the years ahead.
"I'm concerned about how reticent will corporate America be to give guidance going into 2011 with all the unknowns ahead of them," he says. "'11's a difficult year to really benchmark in terms of what it's going to cost corporate America to run their businesses. We don't know now and the great debate doesn't start until after the November election cycle."
That level of uncertainty could force the market to tread water until the election results finally come in.
"We're not going to be surprised by earnings anymore," says Paul Zemsky, head of asset allocation at ING Investment Management in New York. "The real positive surprises—margin expansion and just general positive upside surprises—increasingly are behind us for the moment, unless we get a big surprise."