If recent market action is any indication, investors are reckoning on a sharp rebound in corporate profits next year. But a slowing global economy may make an earnings recovery harder than many think.

It took a little time, but America effectively exported its recession to the rest of the world. The world's largest economy, the U.S., is also the world's largest customer. As demand has fallen here, suppliers around the world have suffered. Japan has entered a new period of weakness, and Europe may have also entered into recession this quarter.

Because the overseas downturns were, for the most part, reactions to the U.S. recession, they came a little later and will probably get resolved a little later, according to Lehman Brothers chief global economist John Llewellyn. Japan, which continues to suffer under the inadequacies of its government in dealing with a debt-ridden and bloated banking sector, is in for another year of contraction. Europe and non-Japan Asia are seeing the same kind of inventory workdown that we've seen here, and that will likely lead to a rebound in the second half of 2002. But since these economies haven't seen the same degree of monetary easing and fiscal stimulus we've seen here, says Llewellyn, "those recoveries will be a damped or muted version of the U.S. one."

Sweet, Acrid, Cherrylike

Around 25% to 30% of

S&P 500

company earnings come from overseas, estimates Morgan Stanley global economist Joe Quinlan. For many U.S. companies, the global downturn will pack a sting. Quinlan also worries that as the U.S. recovers, and other parts of the world continue to suffer, the dollar will strengthen, further sapping overseas profits.

"There will be a decline in overseas earnings next year," says Salomon Smith Barney economist Steve Wieting. "The question is how steep." Wieting reckons there will be a 14% decline in profits from overseas in 2002, and is forecasting that overall earnings for the S&P 500 will be basically flat next year. Most strategists and economists are forecasting stronger growth than Wieting is, while the consensus of company analysts calls for earnings to bounce up 15%.

J.P. Morgan strategist Tom Van Leuven, however, has a similarly dour view on earnings, partly because of the risk of overseas profits declining. He points out that industrial commodity prices have fallen sharply this year -- a market forecast for flagging global demand.

But the stock market, on the strength of the recent rally, appears to have ignored the global headwinds, betting instead on an economic recovery of such strength that declining overseas earnings won't matter. Tech shares have been at the forefront of the rally this fall; the S&P Tech Index is up 50% from its lows and has recaptured summer levels. But tech companies also carry the heaviest exposure overseas: According to Merrill Lynch's quantitative strategy group, 24 of the 50 stocks in the S&P 500 with the heaviest overseas exposure are in the tech sector. One wonders how investors will react when the reality of a slower world economy hits home.