Lame Profits Feed Recession Fears

Year-over-year profits for the S&P 500 slipped 3% in the third quarter, adding to recession fears.
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Declining profit growth adds to the mounting evidence foretelling a possible recession for the U.S. economy.

With the third-quarter earnings season nearing a close, the year-over-year profits for

Standard & Poor's 500

companies declined 3%, according to Thomson Financial. The drop marks the first quarter in five years that American corporations have recorded an aggregate earnings decline. Thus far, 461 companies in the S&P 500 have reported earnings.

The last time investors experienced a negative quarter was in the first quarter of 2002, when the market logged an 11.5% decline. Profit declines during the recession of 2001 included a third-quarter drop of 21.6% and a 21.5% drop in the fourth quarter.

"Profit declines portend recession if they lead to cutbacks in capital spending and labor," says John Lonski, chief economist at

Moody's Investors Service

. Lonski believes there is about a 40% chance of recession at this time, as the housing recession continues to spill over into the rest of the economy.

Recent data suggests both business spending and employment may be on the wane. The Philadelphia Fed and New York Empire State surveys of regional economic activity published Thursday showed that capital spending fell sharply this month. The Philly Fed survey's index of planned capital spending fell to 7.1 in November, compared with a 20.5 reading in October and a six month average of 19.7. The New York survey shows a similar drop. Its index of planned business spending fell to 19 in November from 27.9 in October and a 26.5 six-month average.

Thursday's report of higher-than-expected jobless claims is evidence of cracks in what has been a surprisingly steady employment environment throughout the past year. Jobless claims have moved above their one-year average in four of the past six weeks, while consumer confidence measures reveal consumers worried about the future.

"There could well be a sea change underway," writes Tony Crescenzi, senior fixed income strategist at Miller Tabak and contributor to

RealMoney.com

. He writes that the rising trend of weekly jobless claims may be "indicative of a weakening in labor market conditions that, if continued, would be indicative of an economic recession."

Bank of America strategist Thomas McManus argues in a presentation that the slowing economy combined with rising inflation expectations amounts to "a whiff of stagflation." He adds that this is not a good environment for stock valuations. He further notes that sectors that benefit from inflation -- such as energy, materials, industrials and technology -- have led the stock market through the volatile second half of this year. McManus has an underweight recommendation on equities and bonds. He recommends investors have 25% of their portfolios in cash.

But falling profits do n ot always lead to recession, says Lonski. In 1995, 1998 and the mid-1980s there were periods of weak profits, but no following recession. Lonski adds that the

Federal Reserve's

increasingly frequent injections of liquidity to the financial system, combined with expectations of at least a 25-basis point interest rate cut at the central bank's Dec. 11 meeting, could help the financial sector pull out of its hole and possibly forestall a U.S. consumer pullback, say some economists.

At the very least, financials can use the steeper yield curve, which typically boosts their profits by allowing them to borrow money at short-term, low rates and lend at long-term, higher rates.

Indeed, the sectors that led the market and profit growth higher over the past five years, including financial, consumer discretionary -- which includes homebuilding and home improvement industries -- and energy sectors were the biggest losers this quarter.

The financial sector in aggregate saw profits drop 22% and was led by declines at companies connected to the mortgage lending and mortgage-backed securities market. The biggest drop came at

Merrill Lynch

(MER)

, whose profits fell $4.1 billion from the third quarter last year. Falling in behind Merrill with steep profit declines were

Citigroup

(C) - Get Report

,

Bank of America

(BAC) - Get Report

,

Countrywide Financial

(CFC)

and

Capital One

(COF) - Get Report

.

The consumer discretionary sector's profits also declined 22%, and included sharp declines for

General Motors'

(GM) - Get Report

, as well as more dramatic drops for homebuilders such as

Toll Brothers

(TOL) - Get Report

,

Lennar

(LEN) - Get Report

and

Pulte Homes

(PHM) - Get Report

.

The energy sector did not fall as far, sliding 12% year over year.

Not only were profits weak in the third quarter, but they were also more difficult to predict than ever. For the first time since Thomson began tracking earnings in 1994, the third quarter's results came in below analysts' expectations -- 1.3% below. In a typical quarter, earnings come in about 3.4% above analysts' expectations, says Thomson's John Butters.

"There is no visibility on earnings," says trader and hedge fund consultant Alex Grace, adding that the economic outlook is too opaque to predict profits.

In keeping with TSC's editorial policy, Rappaport doesn't own or short individual stocks. She also doesn't invest in hedge funds or other private investment partnerships. She appreciates your feedback. Click

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