NEW YORK (CNN/Money) - Now was supposed to be the easy part. The economy would be chugging higher and U.S. companies would be raking in the profits.
But instead the third quarter is shaping up to be a dud. With the economy hitting a rough patch, companies have steadily guided down investor expectations and analysts have slashed estimates.
At the beginning of July, according to First Call, expectations were that companies in the S&P 500 would see earnings grow by 16.6 percent over the third quarter last year. Now analysts expect just 11.2 percent -- and still the estimates look overly optimistic.
"Earnings expectations are still too high," said Banc of America Securities strategist Tom McManus. "It's setting us up for a disappointment." McManus thinks expectations assume an economic recovery that just hasn't happened.
Could get worse
After the economy proved resilient to the Sept. 11 attacks last year, investors began to build a "V-shaped" recovery into their expectations (one that would bottom quickly and bounce right back). But the economy had a lot of other problems than 9/11.
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| | Sector | | April 1 | | August 30 | | Communications Services | 14% | -14% | | Consumer Cyclicals | 27% | 21% | | Consumer Staples | 27% | 6% | | Energy | -20% | -24% | | Financials | 48% | 35% | | Health Care | 14% | 2% | | Industrials | 23% | -2% | | Materials | 52% | 23% | | Technology | 132% | 61% | | Transports | nm% | 79% | | Utilities | 8% | -12% | | S&P 500 | 30.3% | 11.2% |
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Source: Thomson Financial/First Call |
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The way analysts have been cutting estimates suggests that they're starting to come around to McManus' view. Numbers came down particularly hard in July. And now that everybody is back in the office following Labor Day, the pace may pick up again.
"Now we're in slash and burn time," said First Call's Joe Cooper. "We think that analysts are going to take down estimates to 5 or 6 percent growth."
Analysts have also been taking down their estimates for the fourth quarter: Growth expectations for the S&P are down to 22.9 percent from 27.7 percent at the beginning of July. This is rare, said Cooper -- usually analysts don't bring down estimates so far in advance.
Slicing into tech
It's technology where the expectations have been most optimistic. In April, analysts expected S&P 500 tech earnings to jump 132 percent in the third quarter. Now, they're looking for 61 percent, still way too high.
The mistake was two-fold. First, there was the belief the economy would keep chugging higher and second, analysts continually failed to recognize that they were dealing with an industry with far too many players and far too much capacity to recover quickly.
"In some industries, there's no improvement and the economy is not going to help them," said Salomon Smith Barney economist Steven Wieting.
Telecom equipment is a case-in-point. Nortel's warning and job cuts last week apparently took some investors by surprise, but it shouldn't have: Orders for communications equipment continue to slump and the industry is running at only 52 percent of capacity, according to the Fed.
But companies in most sectors are running lean enough that, if the economy does pick up steam, they'll be able to post strong earnings, according to Morgan Stanley economist Richard Berner. The question is when the economy will get going and his answer, for now, is sometime around the beginning of the year.
"Earnings are leveraged to growth," he said. "If the economy continues to be sluggish, the earnings are also going to be sluggish."
But maybe with stocks down so much already the market can handle sluggish earnings. AQR Capital's Cliff Asness says that with the S&P 500 P/E ratio at 24, based on its average earnings over the past decade, stocks are "within hailing distance" of reasonable valuations. Not that these are the kinds of levels that make him want to rush in and buy.
"To see a recovery in earnings is not enough," he said. "To be a screaming bull you need to have a radical earnings recovery, or a view that PEs should be 30 to 40."
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