Here we go again.  The baseball playoffs are underway, which means the third quarter earnings reporting period is about to begin.

Today we preview the reporting period, which begins with Alcoa's (AA) report after the close on Tuesday, October 9. 

It is a reporting period that is expected to be long on excuses and short on optimism.  More importantly, it could end up showing that S&P 500 earnings declined for the first time since the third quarter of 2009.

The End of an Earnings Growth Era?

According to Thomson Reuters, third quarter earnings are projected to decline 2.4% while revenue is expected to be down 0.1%.

The last time S&P 500 earnings declined was the third quarter of 2009 when financial markets and the global economy were starting to claw their way back from the worst financial crisis since the Great Depression.

For the third quarter of 2009, real GDP rose at an annual rate of 1.4%.  Not long ago, we heard from the Bureau of Economic Analysis that second quarter real GDP rose at an annual rate of 1.3%. 

A lot has changed between those two periods, yet it is clear that the effects of the Great Recession continue to linger.  Our forecast for third quarter real GDP growth is just 0.9%.

It should be no surprise then, not with so many of the world's major economies experiencing a growth slowdown or an actual recession in the case of several eurozone countries, that the third quarter earnings growth estimate is so lowly.

The surprise in all of this is that the equity market has seemingly disregarded these key fundamental factors, choosing instead to fixate on the idea that unconventional monetary policy will ensure that economic and earnings slowdowns are transitory.

This viewpoint is seen clearly in the chart below.  It shows the divergence between the forward four quarter consensus earnings estimate, which was coming down as the second quarter reporting period progressed, and the S&P 500, which increased in price throughout the same reporting period as macroeconomic weakness raised the expectation that further policy accommodation would be provided by the world's central banks and the Federal Reserve in particular.

Lowered Estimates

With respect to the third quarter specifically, earnings were expected to increase 3.1% as of July 1.  That consensus growth estimate came down amid a string of weak economic data and a flurry of third quarter earnings preannouncements that skewed heavily to the downside.

The negative-to-positive preannouncement ratio for the third quarter is 4.3, according to Thomson Reuters, which is well above the long-term aggregate of 2.3 and the 2.6 ratio seen in the same period a year ago.

A report from FactSet shows that the technology (26), consumer discretionary (17), health care (13), and materials (8) sectors have accounted for the bulk of the roughly 90 negative preannouncements for the third quarter.  In the table below, it can be seen that earnings growth estimates compiled by Thomson Reuters were reduced for every sector, with the exception of the financial sector.

The financial sector stands to benefit this period from earnings growth among the regional bank, diversified bank, and REIT industry groups.  In addition, easy comparisons for Goldman Sachs (GS) and AIG (AIG), which are comping against large losses last year, will help offset the expected decline in earnings growth for Bank of America (BAC) and Morgan Stanley (MS), which were helped last year by one-time gains and debt valuation credits.

Conversely, the energy sector is expected to be the biggest drag on third quarter earnings as lower demand for oil and lower natural gas prices clip the top- and bottom-lines for energy companies.

Downward revisions are commonplace ahead of a reporting period. 

On a certain level, market participants have learned not to fear the aggregate revision as much since companies often show that analysts tend to get too pessimistic just in front of a reporting period. 

Historical data indicate that 62% of S&P 500 companies, on average, report earnings that top expectations.  Last quarter, 67% of the companies reporting exceeded their consensus earnings estimate.

Headwinds

It is possible that S&P 500 companies will surprise again on the high side, yet there are headwinds that have been blowing longer now that suggest either the surprise won't be as strong as prior periods (5% over the past four quarters) or that, perish the thought, earnings estimates weren't reduced enough.

U.S. multinationals are at heightened risk of not living up to expectations given the weakening levels of economic activity that are crimping aggregate demand.  

In turn, the third quarter average for the Federal Reserve's nominal broad effective exchange rate index was 4.8% higher than the prior-year period as the U.S. dollar maintained its safe-haven status.  The stronger dollar will act as a drag in currency translation.

Both FedEx (FDX) and Oracle (ORCL), which had fiscal quarters ending in August, spoke to the macroeconomic and currency headwinds when announcing their results and guidance. 

In turn, lower levels of sales activity abroad could very well mean U.S. multinationals will have to contend with a higher effective tax rate that will cut into net earnings.  Abercrombie & Fitch (ANF) for one warned about this headwind in August when it lowered its full-year outlook.

So, there is a demand factor and a currency factor that will be in play strongly for U.S. multinationals.  The fiscal cliff uncertainty factor, however, will be in play for all and it is likely to be cited by many companies for disappointing results and/or cautious guidance.

On that note, guidance ranges, if they are provided, could be wider than usual to account for the lack of visibility heading into the new year with so many important fiscal factors hanging in the balance in the halls of Congress.

A New Focal Point

For the better part of the past three years, the bottom-line has been the focal point of the earnings reporting period.  That makes sense.  After all, it is called earnings reporting season.  The top-line, however, is increasingly rounding into form as the thing to watch.

The top line is a reflection of aggregate demand, and weak levels of aggregate demand will lead to weak revenue growth.  Weak revenue growth will lead to weak earnings unless companies find a way to expand profit margins that are already near record high levels.

That is a tall order given macroeconomic conditions.  The quality of earnings, therefore, will need to be scrutinized this reporting period.  Share buyback activity could factor prominently for companies meeting, or just beating, the consensus earnings estimate.

It would be remiss not to add that the energy sector is the main reason why revenue is expected to be flat in the third quarter. 

Revenue projections compiled by FactSet show that the energy and materials sectors are actually the only two sectors where third quarter revenues are expected to decline. The energy sector specifically is anticipated to see revenues drop 16.7%. 

All other sectors are projected to post an increase in revenue, with the health care sector leading the estimates with 6.9% growth.  Most revenue growth estimates for the remaining sectors range from 1-4%.  Where there is revenue growth, it will be important to assess how much of it is price-driven and how much of it is volume-driven.

What It All Means

The stock market has rallied strongly ahead of the third quarter reporting period.  It has done so on the back of central bank support and that support isn't going to be pulled anytime soon.

For that reason alone, the equity market could carry on as it has in the face of lackluster earnings results and guidance.

Even so, the third quarter reporting period has the potential to temper some of the market's faith in the Fed should it expose the fundamental divide between the real economy and the alternate reality of rising stock prices riding a wave of liquidity.

The fourth quarter consensus earnings growth estimate is 10% (down from 14% on July 1).  As stated previously, we think that estimate is too high still given the macroeconomic challenges and we expect it to come down in coming months. 

The third quarter reporting period could start on a favorable note with financials taking the early lead, but it would be a surprise if that reporting keel was maintained.

Macroeconomic trends and political uncertainty lead us to believe companies will be short on optimistic outlooks.  Instead, we suspect there will be a proclivity to temper expectations with more cautious-sounding guidance that accounts for high levels of uncertainty on the road ahead for the real economy.

What that means for stock prices in the near term will hinge on the market maintaining its faith in the resurrection powers of the Federal Reserve and other central banks.

--Patrick J. O'Hare, Briefing.com