Investors contracted a pleasant case of attention deficit disorder last week, but the fact remains that earnings comparisons in the third quarter have been the worst in a decade.

While Wall Street bides time looking ahead, analysts are still hesitant to call the bottom, seeing more room below for earnings. Stocks strengthened while the profit reports were rolling in, but analysts say sustainable rallies are only built on earnings improvement. And that won't happen till at least the second quarter of 2002.

"We're anticipating a sequential pickup in fourth-quarter earnings," said Thomas McManus, equity portfolio strategist at Banc of America Securities. "But that's not good enough.

"We prefer to look for the first quarter where there are positive

year-over-year earnings comparisons, and right now we think, and hope, it'll be the second quarter of next year," he said.

About 78% of companies in the

S&P 500

have reported their earnings, and by the end of this week, 86% will have spilled the beans. Since the start of October, the S&P 500 is up 3.8%, while the Nasdaq has gained 14.8%. The Dow Jones Industrial Average, meanwhile, has risen 4.9%.

The disconnect is glaring. Third-quarter earnings for the S&P 500 have so far declined by about 19% from a year ago. The weakest sectors have been transportation, which through Oct. 26 posted 15 cents in losses for every dollar earned last year, and technology, where profits have slipped by about 71%, according to Thomson Financial/First Call. In all, third-quarter profits could fall by about 22%.

The market rallied because many stocks were "completely oversold," said Joe Cooper, analyst at Thomson Financial/First Call, noting that the rally was fueled by companies' ability to hit already diluted estimates. The last time things got this bad was during the second quarter of 1991, when earnings for the S&P 500 dropped by about 24%.

And earnings comparisons will probably get grimmer. Thomson Financial estimates that fourth-quarter earnings could also decline by 22% on a year-to-year basis. Analysts expect the transportation sector to lose 63 cents in the fourth quarter for every dollar it earned a year earlier, as well as a 61% drop for tech. These sectors are "in a free fall," Cooper said.

Any meaningful turnaround is hard to predict at this point, because analysts are still revising their estimates regularly, meaning that comparisons for the next few quarters could get worse. "Right now the market is looking across the valley, and it has been doing that for ages," Cooper said. "Except that the valley has continued to expand; the two walls are getting farther and farther apart."

Catching the Early Cycle

Wall Street is beginning to buy the recovery thesis. Investors have traded some defensive positions for cyclical and growth issues over the past month, as evidenced by the performance of some stocks. For example, blue-chip

IBM

(IBM) - Get Report

has gained 17.2% since Oct. 1, while consumer cyclical stocks like

Coca-Cola

(KO) - Get Report

gained 5.5%. Meanwhile,

Merck

(MRK) - Get Report

, a typically safe bet, has lost 4.5%.

"In general, one wants to be a little more positioned towards an economic rebound," said John Bartlett, director of economic and market strategy at Commerce Bank. Will Braman, chief investment officer at John Hancock Funds, and the head of mid- and large-cap growth equities, agrees. Braman, who sees a profit recovery in the second quarter of 2002, suggests investors should focus on "early cycle sectors" such as retailers, software stocks and some "capital markets-oriented" names, including brokerages and consumer financial services companies.

While capital spending on industrial and tech goods tends to lag an economic recovery, inventory corrections in the electronic and semiconductor sectors are "largely behind us," Braman added.

Nevertheless, equity strategists acknowledge that the big economic picture remains incomplete. "I believe the important thing we're currently missing is pent-up demand," said McManus. He says that the average consumer, whose income is being threatened by rising unemployment, is being "encouraged to spend more and beyond his ability to earn." Consumer demand usually leads a pickup in business spending, McManus said.

Once signs surface that demand has strengthened, McManus said, he'll be looking at consumer discretionary sectors with momentum, "interest-rate sensitive cycle stocks," as well as autos, transportation and housing-related stocks. "But I think it's too early to make that call," he added. "In other words, I think it's too soon to be going for early-cycle groups because the economy's still decelerating."