Bad news is good news ...

Especially if the Fed notices. In the fourth quarter, low expectations might equal solid gains despite lousy earnings and wary consumers.

By Alexandra Twin, senior writer

NEW YORK ( -- On Monday, the first day of the fourth quarter, two of the largest financial companies in the world told Wall Street the bad news it had been expecting for awhile. And stocks rallied, with the Dow hitting an all-time high.

While investors certainly won't be as sanguine about all the other bad news likely to be delivered in the next few months, Monday's positive response - to news that Citigroup (Charts, Fortune 500) and UBS (Charts) were forced to take substantial writedowns due to subprime losses - could signal that the quarter will benefit from lowered expectations.

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"I think the hope with the earnings, and certainly with the banks on Monday, is that they are divulging the worst of it now, so it's only going to get better," said Peter Dunay, investment strategist at Leeb Capital Management.

"There's a sense that the (September) rate cut from the Fed on top of the incredibly low earnings expectations will help stocks move up in the near term," Dunay said.

Just how low are those expectations? Earnings for the third quarter - which will be reported during the current quarter - are expected to have risen just 3.1 percent from a year ago, according to earnings tracker Thomson Financial. That figure could end up dropping even lower in the next few days as analysts adjust their forecasts to account for Monday's news, Thomson said.

Even with no revisions, that 3.1 percent figure would put S&P 500 earnings growth at the worst level in more than 5 years, since the second quarter of 2002, when earnings grew just 1.4 percent.

Yet the outlook for stocks through the end of the year remains fairly positive, partly because of a sense that the worst news has been revealed, and partly on bets that the Federal Reserve will keep cutting interest rates. Of course, whether the Fed actually will keep cutting rates this year is a matter of some debate. (Full story)

Seasonal factors also suggest a solid fourth quarter, if history is to be trusted.

Stocks managed to move higher at the end of a volatile third quarter, which was defined by worries about what the housing and subprime mortgage market meltdown will mean for the financial sector and the broader market.

Wall Street was able to ultimately digest those challenges. Alan Gayle, senior investment strategist at Trusco Capital Management, pointed to several reasons why: Overall market valuations were reasonable, the economy seemingly avoided a recession, core inflation moved back into the Fed's comfort zone and the Fed cut interest rates for the first time in 4 years.

"Against that backdrop, stock investors are sure to face challenges in the fourth quarter," Gayle said. Add to that the likelihood that $80 a barrel oil could finally start to be a factor for consumers as the winter heating season gets underway. Meanwhile, the housing collapse has started to drag on consumer spending - and could have a significant impact on holiday retail sales.

Still, the positive fundamentals that helped Wall Street get through the initial shock of the credit and mortgage market crisis should give stocks a small lift through the end of the quarter, Gayle said.

Granted, the gains could be small. Standard & Poor's has a year-end price target of 1560, around 1 percent above where the S&P 500 ended the session Tuesday and not far from the all-time high of 1553.08 the S&P 500 hit in July.

"We think we'll have a good year overall, up 10 percent, or 12 percent including dividends," Stovall said. "But just as the market was able to tumble as precipitously as it did this summer when it was at the record high, I don't think we are fully out of the woods in terms of the economy and earnings in 2008."

Not to mention earnings in 2007.

Earnings growth forecasts between the first day of the third quarter and the last were cut in half, and it was largely because of financial services firms, said John Butters, director of earnings research at Thomson Financial.

"You're really seeing the impact of the credit issues hitting the financials," Butters said. "They've all seen significant estimate cuts."

He said that on July 1, the first day of the third quarter, financial earnings as a whole were expected to grow 9 percent from a year ago. Now, that number is down to growth of 2 percent versus a year ago. Once Citigroup is fully accounted for, the forecast should turn negative.

But financials aren't alone in dragging down overall third quarter growth. Home builders, which fall under the consumer discretionary sector, get some credit too. Consumer discretionary is expected to show a year-over-year decline due mostly to Lennar (Charts, Fortune 500) and KB Home's (Charts, Fortune 500) poor showings, Butters said.

If you stripped out the homebuilders, the consumer discretionary sector as a whole would be on track for earnings growth of 6 percent in the quarter versus a year ago, he said.

However, earnings are also going to be weak in the quarter simply because they had grown so substantially for so long, posting double-digit earnings for 14 quarters through the end of 2006.

Yet, earnings are expected to improve after a dismal third quarter. Forecasts call for S&P 500 earnings growth of about 11.5 percent in the fourth quarter of 2007 and 10.6 percent in the first quarter of 2008, according to Thomson Financial. Overall 2008 earnings are expected to grow 12.1 percent.

That improvement is mostly attributable to strength in technology, consumer discretionary and energy earnings growth.

Tech earnings are on track to grow 20 percent in the fourth quarter and 14 percent in the first quarter of next year. Consumer discretionary earnings are expected to grow 20 percent in both the fourth quarter of 2007 and first quarter of next year.

And that $80 a barrel oil? Well, it's good news for energy companies. Energy earnings are on track to grow about 13 percent in the fourth quarter and 18 percent in the first quarter of next year, Butters said.

Additionally, the weak dollar, a worry for the broad economy, could be good for the earnings of multi-national companies both in the third quarter and beyond, with big blue chips like GE (Charts, Fortune 500) and Proctor & Gamble (Charts, Fortune 500) benefiting. Top of page