This quarter is significant because it helps investors gauge how the year will end.

At this time of year, children begin to get excited about Halloween, naturalists look forward to fall foliage, and investors become anxious over third-quarter results.

The third quarter is probably the most important of all four, as it helps investors either maintain their optimism toward their full-year forecast and give share prices an end-of-year boost or causes them to adjust their year-end expectations and trigger a sell-off in stocks, as investors act like retailers who "mark `em down and move `em out."

S&P equity analysts now project a 10% year-over-year decline in third-quarter operating earnings for companies in the S&P Composite 1500, which consists of the large cap S&P 500, MidCap 400, and SmallCap 600 indices. The third-quarter earnings estimate has been in a state of flux. S&P equity analysts expected a 2% decline at the end of April.

Four of the 10 sectors in the 1500 are currently projected to post earnings advances. Consumer discretionary companies should see the largest percentage gain, rising 117% from the third quarter of 2008 on a combination of easy comparisons, continued cost-cutting efforts, and the removal of General Motors from the index. Analysts expect a 6% earnings gain in health care and a 1% increase in the profits of telecom services companies. Financials are projected to record their third straight quarter of higher earnings, after recording five successive quarters of losses from the fourth quarter of 2007 through the fourth quarter of 2008.

Earnings declines will remain quite prevalent, led by energy s 74% drop, followed by a 65% expected decrease in materials earnings and a 36% contraction in industrials' profits.

Those sectors that are likely to see a sharp decline in third-quarter, year-over-year earnings estimates have many things in common, including a weak global economic backdrop. But they also have high international exposure, which may have been helped by the recent weakening of the U.S. dollar.

S&P Index Services, which operates independently of S&P Equity Research, estimates that companies in the materials sector receive approximately 50% of their revenues from overseas, as compared with 55% for energy, 46% for industrials, and 48% for the S&P 500.

Energy s shortfall can be partially blamed on tougher comparisons, as oil prices fell drastically (they touched $147 in July 2008 and fell to $104 by the end of September 2008) after the oil bubble burst amid the severe global recession. Also, natural gas prices touched a seven-year low and aren t expected to rise materially until 2011.

Companies in the S&P materials sector also felt the sting of contracting global demand in general and the slowdown in demand from China in particular. We also saw the pickup in the value of the U.S. dollar in a flight to safety move after Lehman Brothers filed for bankruptcy and AIG required a bailout, triggering a freefall in global equity markets. The earnings shortfall for the industrials group is likely due to the continued decline in real gross domestic product (GDP) here in the United States and abroad. In the past year, U.S. GDP shrank 5.4% in the fourth quarter of 2008, 6.4% in the first quarter of 2009, and 0.7% in the second quarter of 2009.

However, we expect a 2.4% expansion in third-quarter GDP. We think this economic recovery won't likely be spelled with either a capital or lower-case V, but rather an elongated U, since we see real GDP growth of only 1.6% for all of next year.

Industry Expectations


Of the 143 industries in the S&P 1500, 87 (61%) are projected to report year-over-year earnings declines. In addition, seven (automobile manufacturers, forest products, home entertainment software, homebuilding, other diversified financial services, regional banks, and specialized consumer services) are projected to repeat losses this quarter (as they did in the year-ago period), albeit at a slower rate.

What's more, eight additional industries (aluminum, consumer electronics, diversified REITs, industrial REITs, oil&gas refining&marketing, photographic products, semiconductor equipment, and steel) are expected to post losses this year versus profits a year earlier. In all, 94 of the 143 (66%) industries are expected to record either losses or year-over-year declines in operating results.??

But "less bad" has been the rallying cry for several quarters, and this one is no different. The expected 10% decline for the S&P 1500 in the third quarter (which follows a 43% drop in the first quarter and a 21% fall in the second quarter), combined with an improvement expected in the fourth quarter, should lead to a 7% gain in operating results for the full year. More-over S&P equity analysts don t think the earnings improvement will end with the new year. They currently call for a 37% advance in 2010. N??

Sam Stovall
Chief Investment Strategist

30-Oct-2009 17:00:12 (14751545)   Copyright 2009 The McGraw-Hill Companies, Inc, Standard & Poor's, a division of The McGraw-Hill Companies, Inc., and their affiliates (collectively, "S&P"). Reproduction of this content in any form is prohibited except with the prior written permission of S&P.