Markets brace for earnings slowdown

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Investors are bracing for the start of what is shaping up to be the worst earnings-reporting season since the end of the recession, as a sputtering global economy and eroding corporate profit margins conspire to stop the earnings recovery in its tracks.

With Alcoa Inc. set to kick off the U.S. earnings season with its third-quarter report on Tuesday, major market trackers estimate that profits from S&P 500 companies fell by 2 per cent to 3 per cent in the third quarter compared with a year earlier. If their estimates are accurate, that would mark the first time since the third quarter of 2009 that U.S. earnings suffered a year-over-year decline.

What could be even worse news for the stock market is what the deterioration in the third quarter may signal for the trajectory of earnings ahead. Companies are entering the time of year when they typically provide guidance to the investing community about their earnings expectations for the next 12 months – and that exercise could pull the rose-coloured glasses off many market forecasters' eyes.

"We feel the consensus [earnings forecast] is too optimistic," said Pierre Lapointe, head of global strategy and research at Pavilion Global Markets Ltd. in Montreal, citing the stagnation of the U.S. economic recovery in recent months.

"We're wary of earnings disappointment over the next month," he said, cautioning that the market could see companies both missing analysts' earnings expectations as well as significantly reducing their fourth-quarter and 2013 outlooks.

"Either way, it won't sit well with the investment community."

Many observers point to a long-expected downturn in historically high profit margins as a key culprit in the quarter's slumping bottom line. But the top line of the income statement also appears to have hit a wall. FactSet estimates that S&P 500 revenues did not grow at all in the quarter.

"We're susceptible to cuts to the 2013 outlook. That's what is going to play out over the next six weeks or so," said George Vasic, head strategist at UBS Securities Canada Inc.

The concern extends beyond the U.S. market, to Canadian and international stocks. Mr. Vasic said "bottom up" forecasts for 2013, based on analysts' consensus projections for the individual companies they follow, are still assuming global earnings growth of about 12 per cent to 13 per cent, despite the sputtering worldwide economy. "They're still way too high," Mr. Vasic said.

Growth projections for earnings in the fourth quarter of this year are running at close to 10 per cent – despite a third quarter that saw the highest proportion of companies lowering their quarterly forecast in more than a decade.

"Double-digit earnings growth is not common in periods of economic slowdown," Mr. Lapointe wrote in a research note last week.

The eroding earnings outlook could deliver a rude wake-up call for investors, after markets enjoyed a summer rally that was largely fuelled by expectations – since confirmed – that the world's leading central banks would provide additional monetary stimulus to support the economy and asset prices.

The rally, in the absence of a rise in earnings expectations to support it, has driven the S&P 500's price-to-earnings ratio – the stock market's key valuation measure – to about 14 from about 12 , based on profit forecasts for the next 12 months. For Canada's S&P/TSX composite index, the P/E has risen to almost 15 from 12, as Canada's resource-heavy market has seen its profit forecasts fall faster than the U.S. market in recent months.

For stock indexes to hold steady at current levels, the P/E valuations will have to climb even further to make up for the expected declines on the earnings side of the equation, strategists said.

"There is some room for valuations to go up from here, but we've used up a lot of that [upside]," Mr. Vasic said. "The upward trend doesn't have a lot of room left."