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Great Expectations for Earnings

Investors expect strong numbers as profit reports roll in.

A few early disappointments notwithstanding, third-quarter earnings season is shaping up as a real bell ringer.

The season got off to a lukewarm start this week with disappointments from

Alcoa

(AA) - Get Alcoa Corporation Report

and

Genentech

(DNA)

. But Friday's penny beat by

General Electric

(GE) - Get General Electric Company Report

should help turn sentiment back in a positive direction heading into next week's rash of reports from the likes of

Yahoo!

(YHOO)

and

Google

(GOOG) - Get Alphabet Inc. Class C Report

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.

All told, Wall Street expects to see double-digit gains across the board for the quarter -- though some observers believe the recent record run in the Dow Jones Industrial Average may cap stock gains even if earnings do come in strong.

"All sectors have been outperforming heading into earnings, so the bar hasn't been raised in terms of earnings expectations," says James Park, managing director with Rodman & Renshaw. "The price appreciation was high going into the news, so instead, we're looking at people selling the news."

Currently, third-quarter earnings are expected to have grown roughly 14%, which would mark the 13th consecutive quarter of double-digit earnings growth. Since 1950, there have been only two other instances of at least 10 consecutive quarters of double-digit growth: between 1972 and 1974 and between 1992 and 1995. In fact, the longest existing streak of 13 consecutive quarters of double-digit growth occurred during the latter's span.

Park notes that there is more of a discount in the market coming into the actual numbers, hence the disappointing moves we saw following the releases from Alcoa and Genentech.

Reading the Barometric Pressures

Many investors keep a close eye on both Alcoa and Genentech for a measure of the health of the market, as typically both signal the unofficial start of the earnings season.

Alcoa, a component of both the

Dow

and the

S&P 500

,

reported its quarterly profit surged more than 80% year over year, but revenue was a bit shy of analysts' projections.

"Alcoa is a perennial disappointment," says Dave Briggs, head of equity trading with Federated. "They don't seem to manage their guidance very well, so it

the results doesn't seem to be much of a surprise."

Indeed, the revenue shortfall was nothing new at Alcoa. The mining company has only exceeded the Thomson First Call revenue target twice over the previous eight quarters, not including Tuesday's gloomy results.

Meanwhile, Genentech

beat analysts' targets on the top and bottom lines and offered upbeat guidance, but sales for some of its individual drugs came up short.

"Genentech's results were not a major disappointment, as earnings and revenue both beat estimates, and the company raised its 2006 earnings-per-share growth outlook again," says Michael Sheldon, chief market strategist with Spencer Clarke LLC. "However, Genentech's revenue trends of some of their biggest drugs were below target, leaving investors wanting more for a high price-to-earnings company."

Robert Pavlik, chief investment officer with Oaktree Asset Management, says that he doesn't see much evidence to support Alcoa and Genentech changing outlooks for the rest of the reporting season.

"While I completely understand why Wall Street tries to find a correlation between what Alcoa and Genentech report and extrapolate it to the rest of companies, I don't see much evidence that this theory holds," Pavlik says.

However, Pavlik points out that Genentech reported its results in July and beat its estimates as did the other biotechs. In addition, he says, several of the major pharmaceutical companies, including

Johnson & Johnson

(JNJ) - Get Johnson & Johnson Report

,

Pfizer

(PFE) - Get Pfizer Inc. Report

and

Eli Lilly

(LLY) - Get Eli Lilly and Company Report

all reported better-than-expected results.

For the overall market, profit growth was larger than many analysts expected, and with any hope, it will be that way again, Pavlik adds, "especially since the decline in oil should translate into lower costs for manufacturers."

Briggs says that the market needs to "get a few more companies in additional sectors before we say the market got ahead of itself. A high-profile tech stock or a health care stock is what I'm waiting for.

"Two companies a trend does not make," Sheldon offers.

So, there's no reason to doubt this earnings season will keep the consecutive streak of double-digit earnings intact. But with fears of an economic slowdown hurting corporate profits, how long will this type of growth remain sustainable?

Current estimates are for EPS growth of 11.8% and 8.7% for the fourth quarter and the first quarter of 2007, respectively. With the outlook for gross domestic product having moderated in recent quarters and record-high profit margins likely to start reversing over time, says Sheldon, it appears that it's only a matter of time before the trend of double-digit earnings growth comes to an end.

"When companies release their numbers in the weeks ahead, forward-looking guidance, as always, will play a major role in determining how stock prices react," Sheldon says.