Corporate Profit Streak Set to End

Aluminum giant Alcoa (NYSE:AA) unofficially kicks off third-quarter earnings season Tuesday, and the market shouldn’t be surprised if the Dow component delivers disappointing news.

It sure wouldn’t be the first bellwether to do so.

We’ve already had warnings from global shipper FedEx (NYSE:FDX); Caterpillar (NYSE:CAT), the world’s biggest maker of construction and mining equipment; and, in an indication of weak domestic demand, railroad operator Norfolk Southern (NYSE:NSC).

Indeed, the ratio of companies slashing guidance versus raising it ahead of reporting season is at the highest reading since the trough of the recession of 2001. That’s partly why analysts expect companies in the S&P 500 to post an aggregate drop in earnings for the first time in 11 straight quarters.

Significantly slower economic growth in Asia, recession in Europe and a U.S. economy expanding just barely above stall speed have third-quarter earnings looking fairly grim. The S&P 500 is forecast to post a 2.6% drop in year-over-year earnings, according to data from FactSet Research. To get a sense of how much the outlook has deteriorated, as of June 30, analysts were expecting third-quarter earnings to increase 1.9%.

Revenue is expected to fare slightly better, but only by remaining flat against the prior-year period. However, not only is that down from expectations of 1.9% growth back on June 30, it also shows that margins have peaked and then some. When profits fall even as revenue remains constant, it means costs are taking a bigger bite out of the top line.

However, not all sectors are created equal. Half of the 10 sectors of the S&P 500 are forecast to post lower earnings for the most recent quarter, while half will post gains — and in some cases, the gains look to be plentiful. Have a look at the expected sector winners and loser in the chart, courtesy of FactSet, below:

Financials are forecast to lead all profit gainers with a 10.4% year-over-year earnings increase. Partly that’s because AIG (NYSE:AIG) and Goldman Sachs (NYSE:GS) are coming up against very easy comparisons. But even after excluding both tough and easy comparisons in the sector, financials are forecast to enjoy broad-based gains.

And thank goodness that they are. Excluding the financial sector, the S&P 500 would post an even steeper drop in earnings, to the tune of -5%.

On the other side of the ledger, the energy sector is expected to report the biggest drop in earnings, at -21.4%. As of June 30, profits there were forecast to slide -15.7%, but sluggish global growth has caused prices for oil and coal to drop sharply from year-ago levels. If energy were excluded from the total tally, the S&P 500 would post third-quarter earnings growth of 0.8%, according to FactSet.

If there are silver linings to these clouds, it’s that expectations are even lower than usual. Yes, we play this game every quarter, with CEOs and Wall Street analysts keeping the bar so low that companies can trip over it.

But, to be fair, it’s better to under-promise and over-deliver. So don’t be surprised if the beat rate comes in as it always does in these post-recession periods, at about 70%.

Furthermore — and more important — the market is forward-looking, and barring wholesale slashing and burning of guidance, the profit picture for the fourth quarter is looking up.

Earnings are expected to end the year with a 9.5% gain, propelled by a 28% rise in financial sector profits and a 26% increase from materials stocks like Alcoa. Revenue is likewise forecast to rebound — and those bottom- and top-line trends are seen extending well into 2013.

Outside of a truly disastrous third-quarter reporting season, any weakness has been more than telegraphed to the market and — fingers crossed — fully reflected in share prices.

As of this writing, Dan Burrows held no positions in any of the aforementioned securities.

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