Profits: Bracing for a second-half surge

Hedging against the credit crunch

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NEW YORK (CNNMoney.com) -- The wretched earnings environment is expected to improve dramatically in the second half of the year, in what may be an early sign that the economic recession or slowdown will be short-lived.

At least that's what the stock market seems to have been forecasting over the last two months. Between mid-March and mid-May, the Nasdaq jumped 12% and the Dow and S&P 500 gained nearly 10% on bets that better economic times are on the way.

Don't break out the champagne just yet. A pick-up in companies' bottom lines may just be a reflection of the sheer unlikelihood that financial sector earnings in the second half of this year could possibly be as terrible as they were in the second half of 2007.

"The comparisons will have to be better, because in the third and fourth quarter of last year, financial earnings fell off a cliff," said Donald Selkin, director of research at National Securities.

In fact, during the fourth quarter of 2007, profits from firms in the financial sector tumbled more than 100% as the credit crisis ramped up amid the housing market implosion. The depth of the fallout going forward remains in question, but analysts seem fairly confident that the second half of the year won't see the same level of multi-billion dollar writedowns. That alone would help the sector, and the overall S&P 500, post better results.

"Analysts are currently calling for sequential earnings improvement," said John Butters, senior research analyst at Thomson First Call. "We'll see how well the numbers hold up as the year goes on, but right now it looks like the fourth quarter of 2007 could have been the bottom for earnings."

Second-quarter profits are expected to fall 6.2% from a year ago. That's not great, but it's better than what happened in the nearly-completed first quarter, in which earnings declined 17%, according to the latest Thomson estimates.

The second half of this year looks even better. Third-quarter profits are forecast to rise 14%, while fourth-quarter earnings are expected to jump 62%.

A lot of that second-half pick up is thanks to financials, which seem to have finally shaken out most of the market-disrupting bad news that resulted in huge writedowns and wild Wall Street swings. It's also attributable to record oil and gas prices. That should prove to be a boon for the energy sector - the largest of the S&P 500's ten subgroups.

Beyond banks and oil. Homebuilders, technology, pharmaceuticals, entertainment companies and even select retailers are also on track to drive growth, said Butters. And that could spell good news for a recovery.

Thomson Financial looked at earnings forecasts for the rest of 2008 - excluding financials and energy - and found that growth in all the other sectors combined was still better than the historic average. That's significant because it means that, to an extent, financials and energy are clouding the larger earnings picture.

The financial sector has by far been the biggest drag on S&P 500 earnings in the first quarter and likely will continue course in the second quarters of 2008 before the group gears up to reverse course mid-year and become the biggest boost during the third and fourth quarters. Energy sector profits are expected to be strong throughout the year.

In the first quarter, banks, mortgage lenders and other financial firms saw profits drop almost 80% from a year ago, while energy sector earnings appear to have risen more than 25%.

Strip out those two areas and the first-quarter picture changes: instead of a 17% decline, the quarter would have risen 3%. Strip out just financials and that number is revised to growth of 7.2%.

Meanwhile, S&P 500 companies outside the financial sector grew revenue by more than 13% in the first quarter. The fact that companies are increasing revenue and not just cutting costs is yet another optimistic development, said Bill Stone, PNC Financial Service's chief investment strategist.

Looking forward, the second-quarter projected loss flips to a profit when both energy and financials are removed. Third and fourth quarter earnings forecasts remain positive even without the help of the financial and energy sector, although the change is pretty dramatic.

The first-quarter of next year looks even better, with S&P 500 earnings expected to soar over 36% from the first quarter of '08. At that point, economic growth should have improved and economists expect that the worst for the housing market will have passed. All of which should help pave the way for a bigger earnings recovery.