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Here Come Earnings, but Forecasts Are Key

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The downgrade of global economic growth by the International Monetary Fund (IMF) this morning provides a fitting backdrop for today's start of third quarter earnings season.

This raises the prospect that most companies will cite the weak economic environment to provide a subdued outlook for the fourth quarter and beyond. And we should keep in mind that unlike for the third quarter, when consensus expectations are for earnings to decline, current expectations are for earnings to stage a robust recovery in the fourth quarter and beyond.

The key question at this stage is whether the expected downward revisions to forward earnings estimates will have any bearing on the market’s recent momentum, which has pushed stocks to new highs for the year and within striking distance of the all-time highs reached in the fall of 2007.

Both companies reporting results today -- aluminum producer Alcoa (AA - Free Report) and fast-food restaurant operator Yum! Brands (YUM - Free Report) -- are exposed to the slowdown in the global economy. Aluminum’s demand comes from the automotive, homebuilding and food processing end markets, among others. It will be interesting to see how Alcoa management characterizes the aluminum demand outlook in the face of a weakening global economy and favorable domestic trends in the homebuilding and auto sectors.

Yum! Brands owes a lot of its ‘growthy’ reputation to its Chinese operations, which is in the spotlight due to that country’s well-known growth problems.

The point is that irrespective of how Alcoa and Yum! do relative to third quarter expectations, what will drive these two stocks tomorrow will be how they guide on the core questions relevant to their businesses for the coming periods. And what is true for these two companies will be true across the board this earnings season.

Expectations for third quarter earnings have come down enough that most companies will likely beat them, as roughly two-thirds of the companies do every quarter anyway. But expectations for the fourth quarter  and beyond remain quite high, with earnings in the fourth quarter expected to reverse the third quarter’s decline (the first in 11 quarters) and bring in a roughly 8% growth.

For full year 2013, total earnings are expected to increase in the low double digits from the 2012 level. But it’s unlikely that companies will be able to achieve earnings growth as the global economy is slowing down, like this morning’s IMF forecast shows.

My sense is that we will see a majority of the companies come out with subdued earnings outlooks for the fourth quarter. And this will cause earnings estimates for the fourth quarter and beyond to come down. And this brings us to the key question of what this expected earnings revisions trend will mean for the market.

Will the market continue to ignore this deterioration in the earnings picture by hiding behind the Fed, as it has been doing thus far, or start taking note? I am of the view that it wouldn’t be able to ignore the weakening earnings trend, but we will find out soon enough.

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