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As Fed Succeeds in Cooling Economy, Earnings Warnings Follow

Alcoa is among the latest blue-chip names to warn of a shortfall.

Wall Street is just as prone as the rest of us to supposing patterns where there are none, extrapolating trends and imposing order on an inchoate world.

So we need to be careful when the market begins to react poorly to earnings warnings by a relative handful of companies. Just as one swallow doesn't make the spring, a couple of companies grousing about slower business doesn't mean that business in general is slow. In fact,


(Institutional Broker's Estimate System) has noted that a higher percentage of preannouncing companies than usual has been reassuring investors that results will be in line with, or better than, expectations.

Nevertheless, there is a theme to recent warnings that is hard to ignore. Along with all the grousing about the euro (it's lower) and oil (it's higher), there has been a suggestion that business is a bit slower than people thought. When


(DD) - Get Report

said that it wouldn't hit third-quarter estimates, it cited not just currency and energy problems but slowing volume growth in some of its businesses. In its laundry list of troubles,



noted "an overall softening in major appliance industry sales, reflecting general economic conditions" when it warned last week. Auto-parts maker



said Monday morning that it was hurt not just by


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tire trouble but by general softness in sport utility vehicles and the light and heavy truck markets. Meantime,


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said it was getting hit by a slowing market for automation products. Monday,


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warned, citing "softening in the transportation, building, construction and distribution markets."

The Slowing Consumer

"Why should it surprise anyone if there are slight business slowdowns?" asks

Salomon Smith Barney

equity strategist Jeff Warantz. "The concept of slowing down the economy -- it has meaning to it. It's not just an abstract idea in a bubble somewhere." It was not for nothing that the

Federal Open Market Committee

raised rates by 175

basis points in 1999 and this year.

The chief drag on the economy has come from the consumer, and this has been duly reflected by the stock market. Poor second-quarter results, followed by poor August sales, have hit retail stocks hard -- the

S&P Retail Index

is down 16.7% this year. Other consumer-heavy areas of the economy have also cooled.

"We've been seeing lots of signs of slowing in domestic demand, starting with a deceleration of consumer spending back in the spring," says Richard Berner, chief U.S. economist at

Morgan Stanley Dean Witter

. Construction has also weakened, in part because of the tougher interest rate environment, in part because there has been a lot of giveback from heightened construction activity during the warm winter.

Theoretically, a slower economy has an outsize effect on corporate profits. This is because there are certain constant costs in running a business -- you have to keep the lights on, the grass cut, the benefits paid and so on. The upside of this is that when business picks up, your profits go up by even more. (Your costs per widget go down as you produce more widgets.) By the same token, when the business environment slows, you take a bigger hit.

A slower economy does not affect all businesses in the same way, however. Though the housing and consumer sectors may be getting hurt, this does not necessarily translate into weaker capital spending (and for "capital spending" you can read "technology" if you like). There will only be a real problem if earnings in the consumer sector get hurt to the point where companies feel as if they cannot afford new capital equipment. For now, that has not been much of a problem -- in a competitive world most companies feel as if they can't afford not to buy the latest productivity-enhancing gizmos.

Killing Two Birds

And this is the major concern when it comes to the high price of energy. Companies that depend on consumers get hurt on two counts: First, they have higher fuel costs, and second, their customers are getting pinched at the pump. As Berner puts it, "The rise in oil prices that we've seen does pose downside risks to growth, and that translates to slower growth in earnings in a very leveraged way."

If these companies' business slows enough to make them cut capital spending, then some sectors that Wall Street had previously thought inoculated against a slowing economy could get hurt.

"Higher oil prices are going to nick everyone, even if there isn't a slowdown," says Scott Bleier, chief market strategist at

Prime Charter

. "I think the whole market is in the process of managing expectations lower."