Earnings: Nowhere to go but up

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NEW YORK (CNNMoney.com) -- Poor results from the banking sector in the fourth quarter are likely to lead to the biggest drop in quarterly profits for large U.S. companies in six years.

With 73% of the companies in the benchmark S&P 500 having reported results, overall fourth-quarter earnings are on track to fall 20.1% from a year ago, according to the latest figures from Thomson Financial.

That's far worse than what had been expected as recently as Jan. 1, when analysts were predicting a drop of 9.4%

"We're really seeing the impact of the credit crunch here," said Jack Ablin, chief investment officer at Harris Private Bank.

Unfortunately for investors, the economic slowdown is likely to make things worse for the next two quarters. Thomson is forecasting a slight drop in profits in the first quarter and only a 1% increase in second-quarter earnings.

But some market experts are predicting that results in the second half of the year should improve, assuming that most of the financial sector writedowns are out of the way.

By the second half of 2008, year-over-year comparisons will get easier, since the third quarter and fourth quarter 2007 earnings were so miserable, said David Dropsey, senior research analyst at earnings tracker Thomson Financial.

Dropsey said that if, as some analysts expect, banks are done writing off most of their exposure to bad mortgages by the middle of this year, earnings could rebound in the latter part of 2008.

Of course, that depends on what happens to the economy. Barring what Dropsey referred to as a "full-blown recession," earnings growth could return to a more "normal" pace, which historically has averaged about 7.6% a quarter versus the previous year.

4Q blues limited mainly to banks

Yes, banks had an awful fourth quarter. With 77 of the 92 companies in the financial sector having reported, the fourth-quarter results from this group are on track to be the worst for any sector since Thomson Financial started tracking earnings in 1997.

The sector has been hit hard by massive losses from heavily weighted companies such as Merrill Lynch (MER, Fortune 500), Bear Stearns (BSC, Fortune 500), E*Trade Financial (ETFC), Morgan Stanley (MS, Fortune 500) and Citigroup (C, Fortune 500)

And because of the losses, Thomson has yet to be able to determine just how big of a percentage drop financial earnings have taken.

But if you strip out the financials, earnings for the S&P 500 would be on track to rise 11.8% versus a year ago thanks to healthy results from several other sectors.

Tech and energy deliver

In particular, technology earnings are forecast to have grown 26% in the fourth quarter, while energy sector earnings are expected to have grown 20%. That strength is expected to continue in the first quarter of 2008, with technology earnings expected to grow 10% and energy 24%.

The performance of tech and energy could add weight to the argument that outside the financial and housing sectors, the economy is holding up better than market psychology would suggest, said Peter Brodie, director of investments at Bryn Mawr Trust Wealth Management.

"Investors have been questioning whether or not we are in a recession and if so, how deep of one we'll see," Brodie said.

He said that the financial sector earnings show Wall Street is still muddling through the mortgage situation, but that earnings growth in other sectors suggests the economic outlook isn't as dire as it appears to be.

Homebuilders and materials struggle

But it's not fair to blame all of the market's earnings woes on the financial sector. Consumer discretionary companies, which include homebuilders, are expected to post an earnings decrease of 15% versus a year ago.

Strip out the homebuilders though and the sector's earnings would be up 6%. The weakness in the financials and homebuilders reflects the credit and housing market crises that have set sent the economy teetering on the edge of a recession.

Beyond housing, there are some indications that other sectors are starting to feel the pinch from a slowdown as well.

Earnings from materials companies, which include chemicals firms, are expected to drop 17% from a year ago, partly due to tough comparisons but also due to a sluggish economy.

Second-half surge?

One encouraging sign for investors is that the earnings picture for financial services companies should start to improve after their dismal fourth quarter.

Granted, financial earnings are still expected to slide in the first quarter. But the erosion is expected to wane, with analysts forecasting a profit decrease of 21%. What's more, consumer discretionary companies are expected to only report a 1% drop in first quarter profits, Thomson forecasts.

The S&P 500 should return to profit growth in the second quarter and that should usher in even higher levels of growth for the rest of the year as comparisons get easier and tech and energy sector earnings continue to show strong growth.

However, Ablin is not so sure that the second half will be quite as robust as some are forecasting. He thinks forecasts are too rosy for the third and fourth quarter and for 2008 overall, particularly for companies outside of technology and energy.

Ablin said he is looking for 2008 earnings growth of about 3%, versus current forecasts for over 15%.