Low Expectations for Earnings Could Boost Positive Surprises

The bar is so low for third quarter profits that the earnings season may end up leaving some stock market bargains in its wake.

Tuesday is the biggest reporting day so far for third quarter reports, expected to show the first cumulative profit decline in three years. Thomson/Reuters expects S&P 500 earnings to drop 2.3 percent from a year ago.

Goldman Sachs, Coca-Cola, Johnson and Johnson, United Health, Domino's Pizza, PNC, State Street and Mattel are among companies reporting Tuesday before the opening bell. IBM, Intel, Cree, CSX and Intuitive Surgical report after the market close.

The message from multinationals, so far, is that soft global growth is hurting profits. The worst hit sectors are those that flourish when the developing world is growing – materials and energy. The ratio of companies guiding negatively versus positively on their earnings this quarter was 4.1 to one, the worst since the third quarter of 2001.

It could be that the companies that are influenced by the U.S. consumer will perform better than expected, according to James Paulsen, Wells Capital Management chief investment strategist. "One of the things we're finding out there is the domestic consumer is in much better shape than we thought 30, 45 days ago, " he said, noting that consumer sentiment rose to a five-year high and September retail sales were better-than-expected. "I've got a feeling retail establishments could report maybe better than anticipated."

By the time the fourth quarter rolls around, corporate profits may be looking better , in part because of an easy comparison from last year.

"When you look at earnings estimates, the third quarter is expected to be the trough and in the coming five quarters, estimates are for gains of between six and 16 percent, " said Sam Stovall, chief equity analyst at S&P/Capital IQ. For that reason, investors picking through the rubble of third quarter results might find some stocks ready to turn around.

Stovall said he would look in groups where the biggest declines are expected. "Chances are you're not going to hit that decline on the nose, and as a result, there is room for opportunity, " he said.

Stovall screened S&P sectors for the ones expected to show the biggest drop, and within those sectors, he looked for stocks positively rated by S&P analysts. Steel makers are also on the list, with an earnings decline for the S&P steel subsector expected to be 81 .2 percent. S&P has positive ratings on U.S. Steel, ATI and Cliffs National, within that sector.

Oil and gas exploration companies are expected to have an earnings decline of 37 percent. Stocks in that group that are favorably rated by S&P includeApache, Devon, Marathon, Noble and Conoco Phillips . Stovall said natural gas drillers have been hurt by the low price of gas, which makes reserves worth less, but that could turn around if natural gas prices keep rising.

Semiconductor equipment earnings are expected to be down 35 percent. Some of the names S&P analysts like in that group include Applied Materials and KLA-Tencor . Electronic components sector earnings are expected to decline 32 percent. Amphenol and Corning are among the stocks in that group that S&P analysts like.

Stovall said S&P's numbers show the expected third quarter earnings decline narrowing, when calculating in the S&P 500 companies that already reported. He said S&P's latest update now shows third quarter earnings for the S&P 500 expected to decline 0.99 percent for the quarter, better than the 1.8 percent decline previously expected.

Paulsen said he thinks the expectations for the bumpy third quarter earnings are already priced in, and the economic data will trump third quarter numbers. "The earnings in the rearview mirror are going to be less influential than the hard data on the ground, " he said. He also said he expects to see the emerging world start to show signs of improvement by the end of the year.

China over the weekend reported a surprise jump in exports, but so far its data picture is mixed at best.

"I think we're finding everything that's not related directly to manufacturing is doing pretty good, and I think we're going to be surprised by most of that, " Paulsen said.

Not everyone sees the third quarter as the bottom for earnings.

LPL Financial chief market strategist Jeffrey Kleintop said he thinks the earnings slowdown might keep going. He thinks the estimates for high double-digit growth next quarter, and solid growth next year are too optimistic.

"This seems unlikely, and exceeding these lofty estimates may prove nearly impossible, " he wrote in a note Monday. "The stall in profit momentum is unlikely to be a mere one-quarter event. Not merely because the economic drag from some combination of higher taxes and spending cuts is likely to further slow the economy in 2013 from its currently sluggish pace of 1-2 percent, but also because of signs that demand and pricing gains have stalled."

Kleintop said softness in pricing should show up in Tuesday's CPI, reported at 8:30 a.m. ET. The sluggishness in momentum also showed up last week in ISM, a manufacturing gauge.

What Else to Watch

Besides consumer inflation data, Tuesday's economic reports include industrial production and capacity utilization at 9:15 a.m. The Treasury releases data on international capital flows at 9 a.m., and there is a National Association of Home Builders sentiment survey, at 10 a.m.

The second debate between President Barack Obama and former Mass. Gov. Mitt Romney is at 9 p.m. at Hofstra University.

Follow Patti Domm on Twitter: @pattidomm

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