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Market Analysis

The fourth quarter reporting season is almost upon us, and consensus expectations are for almost no growth from the year-earlier period. This is a sharp drop from three months back when fourth quarter earnings were expected to be up more than +7%.

My goal in today's write-up is to give you a preview of the fourth quarter earnings season and use that as our framework for the broader earnings story. After all, of the many elements that have a bearing on stock prices, corporate earnings are one of the most influential ... at times referred to as the mother's milk of stock prices.

As regular readers know, I have been skeptical of consensus earnings growth projections, particularly for full year 2013. Driving this skepticism is an economic view -- not just about the U.S. economy, but globally -- that sees no material improvement over the next few quarters.

I am of the opinion that downward adjustments to current earnings estimates will result in a reversal in the stock market momentum of the last few months. Towards the end of the write-up, I discuss how this upcoming bout of negative earnings revisions could be different and potentially more problematic for the market than has been the case thus far.

What is Expected for Q4?

Total earnings are expected to be up +0.4% from the same period last year, with 10 of the 16 sectors experiencing declines. The Finance sector, despite undergoing major downward earnings revisions over the last three months, is alone responsible for keeping the overall growth rate in positive territory. Excluding the +9.6% growth in the Finance sector, total fourth quarter earnings for the S&P 500 would be down 1.2% from the same period last year.

The mighty Tech sector, the largest earnings contributor to the S&P 500, is a net drag on earnings this quarter. Total Tech sector earnings are expected to be down -3.8% in the fourth quarter, after the +0.2% growth in the third quarter. While weakness in the Tech sector is quite broad based, the negative earnings comparison at Apple (AAPL) is not helping matters. Please note that Apple alone will bring more than a quarter of all Tech sector earnings this quarter.

As bad as it looks, these expectations are actually better than what was expected for the third quarter just ahead of that reporting cycle. The actual results will most likely be better than these pre-season expectations, a function of corporate managements' track record of under-promising and over-delivering. That said, earnings growth has been steadily coming down for a number of quarters and a roughly flat earnings growth rate in the fourth quarter would not be that unusual.

What is Expected Beyond Q4?

A more interesting aspect of current consensus expectations is the outlook for the quarters and full year 2013. Earnings growth expectations for the first quarter of 2013 are not materially different from what is expected in the about-to-start fourth quarter. But consensus expectations envision a strong earnings rebound as the year unfolds, particularly in the second half of the year. In fact, the growth rates currently expected for the last two quarters of 2013 would be the highest of the preceding six quarters.

This back-end loaded earnings projection for 2013 accounts for most of the more than +10% earnings growth currently expected for the year. While part of 2013 growth expectations reflect easy comparisons and reduced drag from the Energy and Basic Material sectors, a big part of the growth expectation is reflective of a more optimistic outlook, in my opinion.

Driving the optimism seems to be the view that the forces that held down profitability in 2012 will abate in 2013, particularly in the second half of the year. But with margins already topped-out and revenue growth hard to come by due to the synchronized worldwide economic slowdown, these earnings growth expectations appear vulnerable to downward revisions. My feeling is that the full-year 2013 earnings growth rate will start coming down as companies provide guidance in the coming days. This will be a replay of what happened to growth expectations for the fourth quarter over the last three months. I think we will be lucky if we can achieve half of the currently expected more than +10% growth for the year.

Putting It All Together

I strongly feel that the coming period of negative estimate revisions will serve as a reality check for the market – making it difficult to hold onto recent gains.

Granted, negative earnings revisions would not be a new phenomenon as estimates have been coming down for more than a year now. We should keep in mind however that macro issues (elections, 'Cliff', Europe/China) have been in the driver's seat lately, pushing issues like earnings to the sidelines. And while those issues are far from completely settled, questions about earnings will take center stage.

This earnings season and the associated corporate guidance will likely bring down estimates for the coming quarters. Unless the domestic and international growth backdrop materially improves from current levels, it is hard to imagine full-year 2013 earnings holding up at current levels. My baseline estimate would be for 2% to 5% growth above the 2012 level.

Focus List Update

We made four changes to the Focus List portfolio this week – adding and deleting two stocks each.

We exited our long-standing position in Kansas City Southern (KSU - Analyst Report) to comply with the Focus List operating framework of staying away from Zacks #4 Ranks (Sells) and Zacks # 5 Ranks (Strong Sells), and only adding Zacks #1 Ranks (Strong Buys) and Zacks #2 Ranks (Buys). We booked our 189% gain in KSU shares after it fell to a Zacks #4 Rank, but we remain long-term fans of the company and would not mind revisiting the stock should opportunities emerge going forward. Kansas City Southern was on the Focus List since February 2010. We also exited the profitable National Oilwell Varco (NOV - Analyst Report) position for the same reason after it fell to Zack #4 Rank (Sell).

Replacing these two stocks, we are adding Allstate Insurance (ALL - Analyst Report) and Sunoco Logistics (SXL - Analyst Report). The Allstate pick not only gives us much needed large-cap financial services exposure, but the earnings outlook for this Zacks #2 Rank (Buy) stock looks promising. The roughly 2.1% dividend yield of this well run insurance leader adds to its attractiveness. Sunoco Logistics is a high quality oil pipeline MLP that gives us an additional low risk and high yield stock for the potentially turbulent times ahead (SXL yields an attractive 3.9%).

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