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It's not Halloween that has corporate America spooked this fall. It's how the lingering debt crisis in Europe and the stubbornly sluggish U.S. economy is sucking the blood out of earnings.

With third quarter reporting season getting into high gear, 89 of the companies listed on the S&P 500 have lowered their expectations for earnings. That's abnormally high according to New York-based Thomson Reuters – a research firm that tabulates and crunches earnings expectations from corporations and the analysts who cover them.

Thomson Reuters measures earnings sentiment through the negative to positive, or N/P, ratio. While 89 companies have lowered third quarter expectations, 37 have raised expectations. That puts the current N/P ratio at 2.4 compared with 2.0 at this time last year. Current negativity even exceeds the long-term aggregate. Since 1995 – a period that witnessed the technology tumble of 2000 and the global financial meltdown of 2008 – the N/P ratio has averaged 2.3.

Until now, earnings have been a bright ray of light in a zombie economy, turning in double-digit growth since the meltdown. What the numbers don't say, though, is that much of that bottom-line earnings growth has been coming as the result of cost-cutting and not genuine top-line revenue or sales growth. "A lot of companies are saying there are going to be a lot of job cuts in the next three months – especially in the financial sector," says Thomson Reuters director of consumer research Jharonne Martis.

The numbers support the sentiment. In the first quarter of this year, earnings for the S&P 500 grew by 18.9 per cent compared with the first quarter of 2010, followed by 12.1 per cent in the second quarter. Projections for the third quarter show 14.7 per cent growth followed by 12.5 per cent in the current quarter. From there, earning fall off a cliff.

"All of the sudden, in the first quarter, we see it drop to 8 per cent. That would mark the first earnings quarter of single-digit growth after nine consecutive quarters of double-digit growth," says Ms. Martis.

The big U.S. banks are currently leading the charge down as the positive effects of the largest government bailout in history wane. On July 1 – the start of the third quarter – financials were expected to grow 15.6 per cent over the third quarter of 2010. Now, that growth rate is 3 per cent.

According to Ms. Martis, third quarter growth is being fuelled by a 10 per cent profit gain in technology, thanks in large part to Apple Inc. "The technology sector is very interesting because it's been the only sector that has not suffered from downward revisions. In fact, it's been going up for the coming four quarters," she says.

But even that good news has a dark cloud. The numbers are also not revealing the true weakness of the U.S. and European economies. "The companies that are beating earnings estimates are getting all their revenue growth in Asia and emerging markets and are telling us the weakness is coming from the U.S. and Europe," she says.

Investors have been getting the message. The S&P 500 has gone into negative territory since the beginning of the year – proportionally lower than the drop in earnings. The price-to-earnings (PE) ratio has fallen to 11.5 from 14.1 in 2010. The average PE ratio for the S&P 500 since 1968 is 15.1.

"The stock market is saying the consensus number is crap," says Toronto-based Avenue Investment Management partner and portfolio manager Bill Harris. According to his value model, the price side of the PE ratio has already been adjusted to compensate for even lower earnings. "On the generic S&P 500, analyst expectations are probably way too high, but the stock market has now discounted all of that. Earnings can come way down, but they probably won't come down as much as the stock market has already come off," he says.

Avenue expects earnings to fall 25 per cent from current levels, creating a huge buying opportunity. If that happens, and the price of the S&P 500 stays at the current level, the PE ratio would rise to 15.2 – in line with the 40-year average.

Mr. Harris says stocks are cheap, even at that level, because the average earnings yield – how much the companies are actually making, divided by the number of outstanding shares – exceeds the average stock price: "If the companies are actually making that much money, it can't get that much cheaper."

He says stock prices will get further support from record low borrowing costs. "With interest rates this low, it's hard for the stock market to fall below a certain point."

According to projections from Avenue, PE multiples fall into two categories – companies with stable earnings and companies with unstable earnings – and investors will pay dearly for stable earnings. "If your company is not consistent, your PE multiple has gone way down. If your company is consistent, the PE multiple has gone way up," says Mr. Harris.

Earnings from companies listed in the S&P 500 are generally stable, he says, because the index is heavily weighted to industrial companies such as Tyco International Ltd. and 3M Co. Resource company earnings, on the other hand, are generally unstable because they are generated by fluctuating commodity prices. "TSX earnings are incredibly problematic because 50 per cent of it are wild resource earnings," he says.

That means investors willing to take on the risk of companies with unstable earnings stand to make the biggest gains. For now, Mr. Harris is erring on the side of caution. "I'll pay a high multiple for something that is consistent," he says.