Warning Sickness: From Bad to Worse in the Fourth Quarter

About all you can tell from preannouncement season is that earnings will stink.
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Companies have been falling over themselves to refine their earnings forecasts heading into the end of the fourth quarter. While there's been more of everything this season -- upside and downside surprises and reaffirmations -- it's still clear that the period will be another brutal one for earnings.

According to Thomson Financial/First Call, fourth-quarter year-over-year earnings in the

S&P 500

could drop by 22%, equal to the decline in the third quarter. "While that might seem to indicate a bottoming out in earnings, it absolutely does not," wrote Chuck Hill, director of research at Thomson Financial/First Call. Because profits began their descent in the year-ago fourth quarter, Hill noted, a big decline from that period implies further deterioration rather than a leveling out.

Nevertheless, optimists are taking solace in the higher number of reaffirmations and positive surprises this quarter. While negative preannouncements still outnumber positive ones, the percentage of negative has fallen, compared with previous quarters. Moreover, certain tech heavyweights recently affirmed or raised their estimates.

"It's probably that the fundamentals have bottomed," said Joseph Kalinowski, equity strategist at Thomson Financial. "It has been a steady progression of lowering the guidance over the course of the year, but I think they're starting to get to where they need to be."

1,061 Hail Marys

The fourth-quarter confessional has been especially crowded. Wall Street has so far heard almost twice its average share of preannouncements: 267 positive guidances, 481 negative and 313 reaffirmations. This compares with a total of 687 preannouncements in the same time last quarter, of which 125 were positive, 421 were negative and 141 in line.

"What jumps out at me is that the negative preannouncements

this quarter come to only about 45% of the total," compared with the average 60% rate seen in previous quarters, Kalinowski said.

Also, the flow of positive comments from bellwethers like


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(CSCO) - Get Report


General Electric

(GE) - Get Report

has also been reassuring, Kalinowski said.


Upside surprises, as well as faith in the recovery thesis, have been fueling buyers. Since Sept. 21, when the averages hit their recent lows, the

S&P 500 has gained 17.7%, while the tech-dominated

Nasdaq is up 41%. Tech stars Intel and Cisco are up 76.8% and 70%, respectively.

"We expect a modest increase in S&P 500 earnings for 2002," wrote Morgan Stanley's equity research group in a recent report. "Technology, basics materials and industrial -- all benefiting from easy comparisons -- stand to post the most robust growth."

In his weekly report, Hill estimated that fourth-quarter S&P 500 earnings will be $10.60 a share, down slightly from $10.78 for the third quarter. The seasonally adjusted decline would be much greater, he noted.

As for 2002, analysts currently see a 10.1% gain in earnings, though Hill said the final results probably would be lower. Analysts are still lowering their 2002 estimates, which remain too high, and the outcome could be a lesser gain, Hill said.

Can't Get Much Worse

Depressed 2001 earnings offer easy comparisons for 2002 growth. "I think we're likely to get mid- to high-single-digit gains simply because we're not going to have the same kinds of writeoffs next year," said Peter Canelo, Morgan's investment strategist. But that doesn't mean organic growth. "If



doesn't lose billions and billions each quarter, it doesn't mean things are any better," Canelo said. "All we've anticipated is a recovery from losses; a real economic advance I don't think is in the price."

But Jeff Ament, vice president and financial consultant at RBC Dain Rauscher, believes business conditions actually could be improving. "We've heard it from a few key companies last week, such as


(ORCL) - Get Report

and Cisco," Ament said, and "many people are buying stock on the basis of future fundamental improvement and not what they have today."

The key is to read through the bravado. Last Tuesday, Oracle CEO Larry Ellison wowed the Street by

projecting operating margins of up to 50% in 2002. The stock, which jumped on the news, has so far gained 36% since Sept. 21. Nevertheless, analysts covering Oracle are

more skeptical than the chief executive himself.

Yesterday, the software giant posted lower fiscal second-quarter earnings as software license sales declined amid weak economic conditions. "When the economy improves, we will earn a lot more," CEO Ellison said in a statement.

"A lot of these companies have been wrong in the past," said Kalinowski, "And you have to be skeptical. There's been more companies putting out the fires and holding Wall Street's hands."

"For the longest time everybody's been so focused on U.S. consumers and how they're keeping us afloat," he said. "But the consumer alone isn't going to break us out of this funk. We're definitely going to need corporations and businesses to pick up."