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Handicapping the Q3 Earnings Season

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The third quarter earnings season is almost upon us, with consensus expectations for a low single-digit decline. This would be the first quarterly earnings decline since the current earnings cycle got underway following the end of the Great Recession in 2009.

My goal in today's write-up is to give you a preview of the third 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 am a little skeptical of current earnings growth projections, particularly for the fourth quarter and beyond. 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 of the stock market's momentum from the last few months. Towards the end of the write-up, I discuss how this 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 Q3?

Total earnings are expected to drop 3.2% from the same period last year, with half of the 16 sectors experiencing earnings declines. Revenue weakness accounts for most of the earnings decline, though net margins are expected to shrink a bit as well. Energy, Basic Materials and Autos remain the weakest with earnings declines in excess of 20% each. Finance and Construction are the only two sectors with positive double-digit earnings growth.

Excluding the 17.3% increase in Finance sector earnings, total earnings would be down 6.8%. Tech sector earnings are expected to be flat from the same period last year (up only 0.4%). This compares to growth rates of 7.4% in the second quarter and 15.5% in the first quarter of 2012. Excluding Apple, the Tech sector earnings are expected to be down 4.6% in the third quarter.

Given corporate managements' track record of under-promising and over-delivering, the actual third quarter results will most likely be better than these pre-season expectations. That said, earnings growth has been steadily coming down for a number of quarters and a negative earnings growth rate in the third quarter would not be that unusual. After growth rates of 34.3% in 2010 and 14.9% in 2011, earnings growth has averaged in the mid-single digits in the last few quarters, as has the expected growth rate for the full-year 2012.

What is Expected Beyond Q3?

A more interesting aspect of current consensus expectations is the outlook for the fourth quarter, with total earnings rebounding from the third quarter's decline to positive growth of 7.9%. This reflects roughly flat revenues and strong growth in net margins for most sectors. In fact, the fourth quarter earnings growth, should it turn out as currently projected, will be the best quarterly growth rate of 2012 and the highest since the third quarter of 2011.

While part of the fourth quarter growth rate reflects easy comparisons and reduced drag from the Energy sector, a big part of the growth expectation reflects a more optimistic outlook, in my opinion. Driving the optimism seems to be the view that the forces holding down profitability in the last few quarters will abate in the fourth quarter and beyond (full-year 2013 earnings at close to $116 are expected to be up in excess of 12%).

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 fourth quarter growth rate will start coming down as companies provide guidance on earnings calls.

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 for the market to hold on to 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 macroeconomic forces (Euro-zone issues and more easing from the Fed) have been in the driver's seat lately, pushing issues like earnings to the sidelines. But with the Fed and the Euro-zone now in the rearview mirror, the earnings outlook question becomes far more significant.

This earnings season and the associated corporate guidance will likely bring down estimates for the fourth quarter since management teams typically provide only guidance for the coming quarter. We will have to wait for the fourth quarter earnings season, starting in January, to properly size up full-year 2013 expectations. Unless the domestic and international growth backdrop materially improves from current levels, it is hard to imagine full-year 2013 earnings holding up at close to $116. My baseline estimate would be 2% to 5% above the 2012 earnings estimate of about $102.

Focus List Update

We made two changes to the Focus List this week - adding and deleting one stock each.

We exited our long-standing position in Chipotle Mexican Grill (CMG - Free Report) to comply with the Focus List operating framework of staying away from Zacks #4 Rank (Sell) and Zacks #5 Rank (Strong Sell) stocks, and adding only Zacks #1 Rank (Strong Buy) and Zacks #2 Rank (Buy) stocks. We booked a 108% gain in Chipotle shares before it fell to a Zacks #4 Rank. We remain long-term fans of the Chipotle growth story and would not mind revisiting the stock should opportunities emerge going forward.

Replacing Chipotle on the Focus List is Gap (GPS - Free Report) , which seems to have turned the corner after struggling for a while. Monthly same-store sales and traffic data across all three brands (Gap, Old Navy and Banana Republic) appear to have turned positive, which is showing up in positive estimate revisions. Current estimates for the fourth quarter and full-year 2013 have moved up in excess of 6% and 10%, respectively, over the last two months. In addition to its Zacks #1 Rank, Gap’s 1.4% dividend yield is quite desirable and in-line with our strategy of adding dividend payers to the portfolio.

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