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Why Earnings Look Opaque Beyond Third Quarter

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In this recovery, historical analogies may not apply.

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This week marks the start of the third-quarter-earnings season, as Alcoa (AA) reports earnings on October 7.

The Street is expecting corporate earnings to decline 24.8%, which would mark the first time the S&P 500 has recorded nine straight quarters of negative growth since Thomson Reuters began tracking the data in 1998.

However, that 24.8% drop is still slightly better than the 27.3% fall in the second quarter. In fact, analysts say earnings should show signs of improvement over for the short term, due to cost control, inventory restocking, and easy comparisons against a terrible 2008 -- particularly among the financials.

"Things get less bad this quarter, with smaller year-over-year losses than in the first quarter and second quarter," S&P equity analyst Alec Young tells us.

Looking further ahead, for 2010, the crystal ball of professional forecasters becomes much cloudier and, frankly, your guess is as good as that of any bow-tied CFA working on Wall Street: Nobody really knows how this struggling economy will perform once it's weaned off Uncle Sam's massive federal subsidies.

Last Friday, as the lousy employment report emphasized in gruesome detail, this US economy continues to really suffer. The report was awful. As David Rosenberg of Gluskin Sheff notes, there can be no durable recovery without net job creation and organic wage growth, which were both lacking in the jobs survey.

So, can earnings recover even if employment remains this weak?

Ed Yardeni of Yardeni Research thinks they can. "US companies are scrambling to decouple from the US economy, and are finding more revenues and earnings overseas, especially among emerging economies," the investment strategist writes in a client note.

"Furthermore, even a subpar recovery in domestic revenues could morph into significant earnings growth given all the cost cutting that has been going on during the recession," Yardeni argues.

Charles Rotblut, senior market analyst for Zacks.com, agrees that, at least short term, earnings prospects look better for the market.

He's telling his subscribers to hold less economically sensitive sectors like health care, which he likes, in part, because it's cheap.

He plays the sector by holding the Health Care Select SPDR (XLV), an ETF with holdings including Abbott Laboratories (ABT), Gilead Sciences (GILD), Medtronic (MDT), and Pfizer (PFE).

Rotblut balances out the portfolio by also committing capital to a more aggressive growth sector like technology. Analysts expect technology companies to show a combined 15% decline in third-quarter profits, but then climb 22% in the fourth quarter.

Rotblut holds the iShares S&P North American Technology-Semiconductors Index Fund (IGW), an ETF with holdings including Applied Materials (AMAT), Intel (INTC), NVIDIA (NVDA), and Texas Instruments (TXN).

He also likes the iShares S&P North American Technology Sector Index (IGM), an ETF with holdings such as Apple (AAPL), Cisco (CSCO), and Google (GOOG).
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No positions in stocks mentioned.
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