Companies are warning about declining profits, which could mean trouble for this bull market

Key Points
  • Companies are lowering their expectations for the upcoming third-quarter earnings season.
  • So far, 98 have provided guidance, with 74 percent negative and just 24 positive, the worst ratio since the first quarter of 2016 when corporate America was in an earnings recession.
  • Citigroup strategist Tobias Levkovich said investors' high expectations for profits could cause a hit to markets if earnings disappoint.
Michael Nagle | Bloomberg | Getty Images

After consecutive quarters of near-record profit growth, companies are starting to lower expectations.

With third-quarter earnings right around the corner, companies are cutting their outlooks at levels not seen since the first quarter of 2016, when corporate America was in a profits recession.

In all, 98 companies have offered guidance — 74 have provided a negative outlook, meaning they expect earnings to come in below Wall Street estimates, while just 24 have been positive, according to FactSet. The 76 percent negative-to-positive balance is above the long-term average of 71 percent.

Moreover, it comes at a pivotal moment as the Dow Jones industrial average and the both hit records last week.

Source: FactSet

Earnings have been on a roll lately, with both the first and second quarters posting growth rates around 25 percent. Those growth rates, though, are expected to diminish considerably. The third quarter is projected to come in at 19.3 percent while the fourth quarter likely will slow to 17.3 percent, resulting in a full-year rate of a robust 20.4 percent, FactSet estimates.

In 2019, those numbers change: 7.1 percent and 7.3 percent for the first two quarters, respectively, and a full-year rate of 10.3 percent.

‘I wouldn’t be surprised to see another correction,’ long-time bull Jeremy Siegel warns
‘I wouldn’t be surprised to see another correction,’ bull Jeremy Siegel warns

While that's still a healthy growth rate, investors need to be attuned to changing expectations and what that might mean for the market.

Tobias Levkovich, chief U.S. equity strategist at Citigroup, cast some doubt on the expectations for 2019, telling clients, that "we believe current double-digit forecasts for profit growth seem excessive. Thus, caution may be appropriate."

Tariffs, rates, strong dollar

With the market basing much of its prolonged rally in 2019 on surging profits, a falloff could be important.

"Given ebullient investor sentiment, we do not think there is much room for companies to disappoint without taking a hefty toll on share prices," Levkovich said. "Notably stronger dollar and higher interest rates plus some softness in emerging economies all intimate the potential for misses. We also wonder how CEOs and CFOs will respond to questions about the impact of trade sanctions."

The impact of the U.S. tariff war with China indeed will be a closely watched point for investors listening in to earnings calls. So, too, will be higher interest rates, inflation concerns and the general status of an economy that has been growing decidedly above trend since 2017.

At a sector level, discretionary, staples and financials have been showing weakening trends, with media, autos, diversified financials and energy slowing, Levkovich said.

"Too few investors focus on the impact of cyclical businesses for [earnings per share] growth, in our opinion, and thus significant misconceptions abound," he said. "We still worry that portfolio managers are anticipating too much from Corporate America and thus missing lofty expectations might be the catalyst for a pullback."

Earnings season unofficially kicks off Oct. 12 when the major Wall Street banks start reporting.