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Worst Quarter in Five Years?

If estimates hold, third-quarter earnings for the S&P 500 will show an increase of only 1.4%.

Though the major averages in the U.S. closed out the third quarter with strong gains, the extent of the subprime mortgage and liquidity crisis that plagued financials and rattled global markets during the summer remains to be fully seen.

Many traders and investors are hoping that the upcoming swarm of third-quarter earnings reports will finally give a reliable indication of how much spillover businesses will have to contend with.

The earnings season unofficially kicks off Tuesday, when basic materials giant


(AA) - Get Report

reports after the closing bell.

As of Friday, Thomson Financial pegged overall third-quarter earnings growth for the

S&P 500

at an anemic 1.4% rate. Should that come to pass, it would be the worst performance since the second quarter of 2002, when earnings rose by the same amount.

Analysts note that a weaker U.S. dollar, which continually set record lows against the euro during the third quarter, undoubtedly aided some export-heavy sectors. Unfortunately, the belief is that housing woes and a slowdown to the U.S. economy will sabotage profit growth for many.

"Downward estimate revisions have already come in from the banking sector, consumer finance, and mortgage companies," notes John Butters, research analyst with Thomson Financial.

As the

Dow Jones Industrial

crossed back above the 14,000 level last week, though, it became apparent that traders believe the estimate is unreasonably low, and that they expect companies to surprise to the upside during the reporting season.

"It's a low bar and an easy hurdle to overcome, just as in previous quarters," says Paul Mendelsohn, chief investment strategist with Windham Financial. "When all is said is done, we could still come out with a growth rate of 7% or 8%."

Robert Pavlik, chief investment officer with Oaktree Asset Management, also doubts earnings will reach double digits, but concedes that it's "very difficult to gauge what damage the credit concerns did."

Heading into the second-quarter reporting weeks, profit growth was seen as coming in at about 4%. However, many companies exceeded expectations and the final growth rate was close to 8%.

"We think that may be likely again this quarter, although financial companies are a large part of the S&P 500, and financial-company writeoffs may play a larger role in the third quarter," says Bruce McCain, senior vice president and head of strategy for Key Private Bank's Investment Management Unit.

Several finance names have already posted mixed results due to the mortgage mess.

Lehman Brothers



Goldman Sachs

(GS) - Get Report

were bright spots among those having already reported, while

Bear Stearns



Morgan Stanley

(MS) - Get Report

delivered poor results.



(C) - Get Report



(UBS) - Get Report


E*Trade Financial

(ETFC) - Get Report


Bank of America

(BAC) - Get Report


Merrill Lynch


have also warned that turmoil in the credit market will impact earnings.

"We are beginning to see significant writeoffs, and there is always a tendency to throw in the kitchen sink when writeoffs become widespread within a sector," says McCain.

It should also come as no surprise that housing names are expected to hand in the worst of the earnings reports. Already,

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KB Home

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have had ugly numbers.

As Mendelsohn points out, though, the market is prepared for the financials to report lower and for housing to be a disaster. Therefore, investors need to look elsewhere.

The decline in the dollar is especially critical for the industrial sector, including

General Electric

(GE) - Get Report



(HON) - Get Report

. They are due to report on Oct. 12 and Oct. 19, respectively.

"Having a stable dollar is important. It's losing buying power everyday, which is not good for the American consumer," says Mendelsohn. "Businesses operating overseas are going to make American goods cheaper overseas."

As the consumer accounts for almost 70% of the U.S. economy, analysts say that spending needs to remain reasonably firm in order to top the Thomson Financial target.

"We would be especially concerned if we see signs of surprising cutbacks of consumer spending as companies report their earnings," says McCain.

Consumer discretionary companies -- especially apparel retailers -- are expected to have been hit the hardest, according to Thomson Financial. Pavlik argues that it may even top financials as the weakest performer of the quarter.

Analysts are also quick to point out

Dean Foods

(DF) - Get Report

as evidence there are issues not completely related to the credit crunch affecting consumer spending. Dean Foods cut its earnings forecast and reduced its work force due to higher milk prices.

"Higher milk prices and other commodities are driving consumers away from brand names to compensate for price," says Mendelsohn.

On the bright side, commodity prices might help those names tied to the energy sector, where companies like


(XOM) - Get Report



(CVX) - Get Report

routinely report record numbers. Of course, oil prices hit their highest level ever during the third quarter and gold tapped a 27-year high.

Technology is also expected to deliver a strong quarter, as it's one of few sectors that has come through the credit storm relatively unscathed.


(AAPL) - Get Report

introduction of the iPhone and its new line of iPod MP3 players make it one of the early favorites.

"These are the sectors and the companies that have held up the best throughout the credit crisis, and they've attracted lots of attention," Pavlik says. "I'd like to see them deliver, but it does make me a little nervous because they've had quite a run recently."

Thomson Financial, though, projects that the best performing sector of the third quarter will be health care, expected to have a 12% expansion rate.


(MRK) - Get Report



(UNH) - Get Report



(AMGN) - Get Report


Bristol-Myers Squibb

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are all due to report over the next two weeks.

Analysts also hope that guidance out of technology, industrials and even materials names will help support a year-end rally despite concerns about the effects of a weaker dollar and inflationary pressures. As usual, projections for the fourth quarter could have more of an impact than third-quarter earnings surprises.

"Conceptually, changing trends seem more likely to show up in guidance than in actual earnings," says McCain. "We expect earnings surprises to be modest but positive, with the major news coming again from guidance about the future."