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Good run of profit gains comes to a close

Reflecting the outlook for earnings season, expectations have tumbled for Alcoa, with analysts reducing their consensus estimate for profit from 7 cents a share to a loss of 1 cent a share.

Jason Cohn/Reuters/Jason Cohn/Reuters

U.S. companies have defied economic gravity in recent quarters, reporting double-digit profit gains despite high unemployment and a lacklustre recovery.

But that string of extraordinary performance is now nearing an end. As corporations begin to report financial results for the fourth quarter, expectations are plummeting.

Earnings are expected to grow only modestly, highlighting the dangers of a weakening global economy. With profits near record highs, the risk is growing that this reporting season will mark the start of a period in which companies' results in both the United States and Canada finally feel the bite of reality.

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Members of the Standard & Poor's 500 index are forecast to have increased earnings per share by an average 7.2 per cent in the last three months of 2011. That figure is just half of what was anticipated at the start of the fourth quarter, and it is a long way off the 39-per-cent growth reported a year earlier, according to S&P.

The trend is highlighted by Alcoa Inc., which kicks off the unofficial reporting season today. Over the course of the past month, expectations have tumbled for the company, with analysts reducing their consensus estimate for profit from 7 cents a share to a loss of 1 cent a share. Last Thursday, the company said it would cut deeply, closing 12 per cent of its global smelting capacity.

For more than two years, U.S. companies have been squeezing more profits out of their operations by cutting costs and improving efficiency. But in most cases, they have not significantly boosted sales.

"I have been surprised by how [profit]margins have continued to increase quarter after quarter and I'm very skeptical that gains can continue," said Francisco Torralba, economist for Morningstar Investment Management in Chicago.

"Those margins have to fall at some point. It's very difficult to time exactly when the margin cycle will end. But I think we are at that point."

Many economists anticipate that the U.S. will experience a mild economic downturn this year as the euro zone and emerging markets see a pronounced slowdown. But Mr. Torralba is more pessimistic, fearing that the U.S. economy will actually contract in the first half of the year.

Instability in Europe will likely increase, possibly with a sovereign default or bank collapse. The effect will be felt in North America through tighter lending and weaker real estate markets, he said.

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One of the indicators of the coming slowdown is the sky-high ratio of U.S. corporate profits to GDP. After sinking to a low of less than 7 per cent during the recession in 2009, corporate profits recently hit 13 per cent of GDP, the highest point in more than 60 years.

This metric traditionally peaks several quarters before a recession. If forecasts for the fourth quarter prove accurate, the third quarter may turn out to have been the earnings peak in the current cycle, Mr. Torralba said.

Weaker corporate profitability and a rising aversion to risk over the next few quarters should lower stock returns, at least in the first half of the year. Whether stocks will gain over all in 2012 depends on how long the downturn lasts. Regardless, there is only a small chance of meaningful gains this year, Mr. Torralba said.

Tom Caldwell, chairman of Toronto brokerage Caldwell Securities, agrees that expectations for the fourth quarter are low, but he expects executives to take advantage of negative sentiment to further strengthen their balance sheets by dumping underperforming assets and incurring costs for additional layoffs.

"In negative environments, corporate managements usually write off everything but the kitchen sink. It's a case of setting the stage for the next fiscal period. If the expectations are negative, that's a significant opportunity for managers to clean the balance sheet," he said.

"The markets are expecting some pretty glum things ahead. So I think [executives]are going to try to clear the decks and I think it will be more of a one quarter [occurrence] If it is a bad quarter, I don't necessarily think it is going to be indicative of a bad year coming."

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