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Good news and bad news for earnings

If you strip out results from big banks, earnings will actually increase in the fourth quarter. But if the economy enters a recession, profits may not hold up in 2008.

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By Alexandra Twin, CNNMoney.com senior writer

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NEW YORK (CNNMoney.com) -- Fourth-quarter earnings are expected to be miserable. And while it's not nice to point fingers, there's really only one sector to blame.

Yes, financials, we're talking to you.

"It's pretty much all their fault at this point," said David Dropsey, senior research analyst at earnings tracker Thomson Financial.

That's because profits for the largest companies in the financial sector - including big banks like Citigroup (C, Fortune 500), which reported a fourth quarter loss of $9.83 billion, or $1.99 per share, Tuesday - are forecast to fall 74 percent during the fourth-quarter, according to Thomson Financial.

To put this in perspective, the nation's largest financial companies earned about $25 billion in the fourth quarter of 2006, Dropsey said, and are expected to lose about $10 billion in the fourth quarter of 2007.

And the biggest banks and investment banks, firms like Bank of America (BAC, Fortune 500) and Merrill Lynch (MER, Fortune 500), are expected to report a combined loss of $5 billion in the fourth-quarter of 2007, compared to earnings of $9 billion in the fourth-quarter of 2006.

Profits for the entire banking sector are expected to fall 59 percent year-over-year.

But as IBM (IBM, Fortune 500)'s strong earnings Monday made clear, other areas of the market, such as technology, are not in bad shape. Energy companies are expected to report a strong fourth-quarter thanks to record-high oil prices.

Healthcare, utilities and even telecom companies are forecast to see decent earnings growth in a tough quarter on Wall Street.

So bank stocks should be single-handedly responsible for the worst S&P 500 earnings growth in nearly six years. According to Thomson estimates, profits for the S&P 500 are on track to drop 12.5 percent in the fourth quarter from a year ago.

Actual earnings tend to beat estimates by a few percentage points each quarter, so the fourth quarter loss could end up being narrower than currently expected, but probably not by much.

And if you strip out the 17 companies that make up the financial sector, earnings are forecast to grow 11.4 percent in the quarter.

"You're really seeing the impact of the mortgage meltdown," Dropsey said. "We're getting better numbers out of almost everyone else."

Terrible bank earnings aren't a surprise, in light of the credit and mortgage market malaise that's wreaked havoc on Wall Street for months. Most of the major banks have announced that they will be taking multi-billion dollar writedowns to account for bad debt. (Full story).

That impact was also felt in the third quarter, when weak financial earnings growth caused the earnings for the S&P 500 to decline as well.

The terrible second half from the financial sector means overall 2007 earnings for the S&P 500 are on track to be flat, with growth of just 0.5 percent expected.

But investors are now turning their attention to the first quarter and all of 2008. Despite hopes of a profit rebound, there is cause for concern.

First-quarter 2008 earnings are currently expected to rise 5.8 percent from a year ago, Thomson estimates. Sectors like technology, telecom, health care and energy are expected to continue to post double-digit earnings growth in the first quarter, offsetting expectations for further weakness in financials.

Beyond the first quarter, the outlook is very murky though. Full-year 2008 earnings are expected to grow 16.2 percent from 2007 but that target reflects analysts' current bets that second half earnings will make up for first half weakness, both in the financial sector and beyond.

Problem is, these estimates don't incorporate whatever additional bad news the banks will deliver in the coming months, nor does it account for how a recession would batter earnings. Chances are, those forecasts will come down quite a bit.

"Earnings estimates have come down for the immediate quarters, but looking out to later in 2008 and 2009, the forecasts are still too high," said Ed Clissold, senior analyst at Ned Davis Research. He said that this reflects the tendency historically for market analysts to keep forecasts too strong at earnings peaks and not account for a bigger slowdown that is unfolding.

Jack Ablin, chief investment officer at Harris Private Bank, thinks a forecast of 3 percent for overall S&P 500 earnings in 2008 would be more reasonable than current forecasts, noting that too many on Wall Street remain "wildly optimistic" about the outlook.

Strong sales of products to countries outside the U.S. that are still growing rapidly could lessen the blow somewhat this time around if the economy heads into a recession.

That's because many large cap companies in the S&P 500 do a sizable portion of their business overseas. These multinational firms are also benefiting from a weak dollar, which encourages other countries to spend on U.S.-made goods.

Still, if history is any guide, corporate profits do not hold up well when the economy is in a significant slump.

The last recession occurred between March and November 2001, according to the National Bureau of Economic Research, a private group that makes the official call. But profits were in free fall a year before that following the bursting of the tech and telecom bubble.

Earnings for the S&P 500 plunged 16.2 percent in 2000 and 17.3 percent in 2001. And the previous recession between July 1990 and March 1991 corresponded with five straight quarters of profit declines, according to Thomson Financial.

So if the economy goes into a recession in 2008, the earnings slump will likely spread to sectors beyond the housing and mortgage markets, analysts said.

"The slowdown in the economy will be reflected more accurately in the forecasts for future quarters, not the fourth, and that's where investors are really worried," said Bryant Evans, portfolio manager at Cozad Asset Management. To top of page

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