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Investors brace for chilly earnings season

The stock market is about to confront a quarterly earnings season, the likes of which it hasn't seen in a while: One where about the only thing growing significantly are the doubts.

The coming flood of first-quarter financial reports begins in the U.S. market this week. Earnings researchers at Thomson Reuters peg analysts' consensus year-over-year earnings growth estimate for the S&P 500 at 3.3 per cent – which would be the weakest performance since the 2009 third quarter. Companies issuing profit warnings – indicating that the quarterly earnings will be weaker than previously projected – have outnumbered those increasing their earnings targets by a rate of 3-to-1, the widest gap since the end of 2008.

"We've seen the estimates come down quite a bit, and even so, we're still seeing a lot of negative pre-announcements – companies are warning that they won't even reach those lower targets," said Gregory Harrison, corporate earnings research analyst at Thomson Reuters.

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As usual, the first big earnings out of the gate for the U.S. market is aluminum giant Alcoa Inc., which reports its first-quarter financial results Tuesday, after the stock market closes. Consensus estimates compiled by Bloomberg point to a loss of 4 cents (U.S.) a share, down from a profit of 28 cents a year earlier, and a 3-per-cent decline in sales.

Alcoa's expected numbers reflect many of the key factors facing the market as a whole this earning season. Sales growth is deteriorating, especially from overseas sources; profit margins are feeling the pinch, amid high costs for fuel and raw materials; and earnings expectations have been eroding as a result.

"Analysts are taking sales estimates down twice as often as raising them, suggesting a widening gap between top- and bottom-line expectations," said Merrill Lynch strategist Savita Subramanian in a research note last week.

Mr. Harrison said as many as 20 per cent of the S&P 500 companies are expected to report a decline of earnings despite an increase in revenues – a stark reversal from the earlier recovery in the earnings cycle, when large numbers of companies produced earnings growth in the absence of revenue growth, thanks to deep cost-cutting and rapid margin expansion.

"This quarter there's definitely pressure from high costs, specifically energy costs," he said. "That's putting pressure on margins."

In addition to rising costs, U.S. companies are feeling the pinch from their overseas operations, amid a stagnant Europe and a slowing Asian economy. As much as half of S&P 500 revenues come from outside the United States.

"S&P 500 profit margins are estimated to decline in [the first quarter]… a function of slowing global growth, as reflected in falling revenue growth expectations," wrote Barry Knapp, head of U.S. portfolio strategy at Barclays Capital in New York. "We still think consensus expectations for profit margins are too high."

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George Vasic, chief strategist for UBS Securities Canada Inc., noted that S&P 500 revenue growth at the end of last year was running at nearly 8 per cent – far outpacing growth in the U.S. and global economy.

"That looks like it has to slow," he said. "And given that margins are already high, the question is whether we're running out of room."

"Quarterly results may generate the next obstacle for investors," wrote Tobias Levkovich, head U.S. equity strategist at Citigroup in New York, in a note to clients last week. "Investors have become a bit too accustomed to upside surprises and upward earnings estimate revisions, such that the first-quarter reporting period may not provide the same kind of upbeat news flow."

The counter-argument, however, is that investors' expectations for first-quarter earnings have now been beaten down so low that it would actually be hard to disappoint the market. Indeed, Thomson Reuters noted Monday that among the handful of smaller S&P 500 companies that have reported their results ahead of Alcoa, nearly 80 per cent have surpasses consensus earnings estimates.

Stocks also look priced for considerable earnings disappointment this year. The forward price-to-earnings ratio on the S&P/TSX composite index, which is based on forecast earnings over the next 12 months, sits at 12.5 times – well below the historical norm of about 14.5. U.S. valuations aren't much better, with the S&P 500 sitting at a forward P/E of about 13.2 times.

Mr. Vasic recently calculated that this gap implies the market is "discounting earnings that are about 15 per cent lower" than current consensus forecasts for the S&P/TSX.

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"The retort is that we don't deserve higher multiples [because]margins have peaked," he said. "But we would counter that that's still allowing for a pretty large buffer."

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