Earnings season: How low can you go?

Amid a clear weakening in incoming economic data, third-quarter earnings are coming in a bit ahead of expectations…again. Shocking I know. Corporate management teams have become so adept at lowering the bar that a lame horse could clear it with ease.

Prior to the start of earnings reports earlier this week, expectations for S&P 500 earnings growth had dropped to -5 percent for the third quarter, according to FactSet. But optimists take heart. If we eliminate the drag from the energy sector, which is expected to post an earnings decrease of as much as 65 percent due to the crash in energy prices, overall S&P 500 earnings are actually expected to rise a bit – a very little bit.

But this doesn't seem so bad in an environment of weak economic growth outside the U.S., a dramatic rise in the value of the dollar, and plunging commodity prices. Yet again, Corporate America shows its vibrancy and resiliency!

business man limbo how low can you go
John Lund | Getty Images

Perhaps more important than the decrease in earnings, though, is the expected decrease in sales. S&P 500 sales are expected to drop a little over 3 percent in the quarter, making it the third quarter in a row of falling sales. But here again, if we eliminate the drag from the energy sector, S&P 500 revenue is expected to grow at the same positive single-digit pace as energy-adjusted earnings. Again, not so bad given the circumstances, right?

Not so fast. If recent history is any guide, earnings will come in significantly ahead of expectations, while revenue will not. In the second quarter, for example, less than half of S&P 500 companies beat their sales estimates while nearly 75 percent beat their earnings estimate. And this is not an anomaly. Among the 58 companies that have reported third-quarter results so far, the ratios are almost exactly the same – less than half beating on sales and about 75 percent beating on earnings. Corporate management teams have been able to effectively sandbag their earnings guidance while they have generally not been able to clear the bar for sales. Should the continuation of this trend be troublesome? In short, yes.

Since the financial crisis, companies have been able to generate strong earnings growth through many factors other than top-line growth. Expenses have been well-managed through layoffs, deferrals of investment, and scant increases in employee compensation. In other words, all the excess labor and production capacity resulting from the Great Recession has allowed corporate America to put up huge increases in earnings on only modest increases in sales.

At the same time, financial engineering such as debt refinancing, stock buybacks and lower tax rates have juiced earnings as well. The result has been record-high corporate profit margins, some 50 percent above long-term averages. While a boom for stock prices thus far, these cost-cutting and financial-engineering initiatives are not sustainable sources of earnings growth. Companies are going to have to figure out ways to grow the top line in an environment of continued weak demand.

Corporate earnings are not reflecting the true underlying state of the economy, and they haven't for some time. Economic growth continues at the same 2.0 percent to 2.5 percent inflation-adjusted pace, plus another 1 percent to 2 percent of inflation, since the end of the recession in June 2009. Yet investors have become accustomed to earnings and stock-price increases well in excess of nominal economic growth. Is reality finally catching up with us? It sure seems like it.

Notwithstanding the crash in commodity prices, which we acknowledge has positive as well as negative effects on corporate earnings, it will be very difficult for Corporate America to keep expanding its profit margins. At the very least, a tighter labor market and higher interest rates seem certain to negatively affect margins at some point in the not-too-distant future. The strong dollar is not helping matters either.

So, once again, the bar has been set pretty low for this earnings season. And investors will still be able to scapegoat the energy and materials sectors for any earnings declines. But we are inching ever closer to the point where earnings growth can no longer come from margin expansion alone. The onus of higher earnings, and therefore higher stock prices, will increasingly fall on the top line.

Commentary by Michael K. Farr, president of Farr, Miller & Washington and a CNBC contributor. Follow him on Twitter @Michael_K_Farr.