Low Bar for Profit Reports

Expectations are down sharply, but investors remain optimistic.
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While the first quarter of 2007 became the wildest ride for the U.S. stock market in years, Wall Street emerged from the turmoil largely unscathed.

Now earnings reports for the period are due, and investors remain optimistic even while growth expectations have declined sharply. Meanwhile, the low bar being set could provide the potential for some upside surprises.

Wall Street expects average first-quarter earnings growth of only 3.3% for the

S&P 500

, according to Thomson First Call. That would be the first single-digit growth rate recorded by the index after 14 consecutive quarters of double-digit rises. (Standard & Poor's, using a different measure of operating earnings, reported 8.9% growth for the fourth quarter of 2006. Thomson's measure showed a 10.6% rise for the period.)

"What's really amazing is how far analysts have brought their earnings estimates down over the last few months," says Peter Dunay, chief market strategist with Leeb Capital Management. "Expectations have become very low, so that should give many companies a chance to surprise investors on the upside. That said, this is a four-year bull market now, so it's getting tired, and there are a lot of things to worry about."

At the beginning of the year, Wall Street expected the S&P 500's first-quarter earnings to rise 8.7% from a year earlier, according to Thomson. While that still would have marked a slowdown from double-digit profits, growth around 9% would continue to reflect strong earnings power and economic vitality for the U.S.

Most economists and market watchers predicted that the economy and corporate earnings would moderate in 2007 amid a slowdown in the housing market, but they projected a rebound later in the year and in 2008 as the

Federal Reserve

began to cut rates and lay the foundation for a so-called soft-landing scenario.

Then came some rude awakenings. In late February, a selloff in the red-hot Chinese stock market sparked the largest one-day drop for the

Dow Jones Industrial Average

since the days following the terrorist attacks of Sept. 11, 2001. Later, a rash of defaults in the subprime mortgage market led to sharp selloffs in shares of lenders such as

Accredited Home Lenders

(LEND) - Get Report

,

Fremont General

(FMT)

and the now-bankrupt

New Century Financial

(NEWC)

.

Also, recent economic readings have shown an uptick in inflationary pressures and strength in labor data, casting doubt on the Fed's ability to lower interest rates anytime soon.

As investors responded by factoring more risk into their stock valuations, analysts slashed their forecasts for earnings growth by almost two-thirds to the 3.3% estimate. The S&P 500, however, emerged from the chaos with a gain of almost 2% so far for the year.

"I'm a little perplexed that the stock market doesn't appear to be concerned by the decline in earnings estimates," says Sam Stovall, senior investment strategist with Standard & Poor's. "Stocks seem to be holding up because the employment numbers have been so strong. If companies are still hiring workers, that means they expect earnings to continue to improve."

While Wall Street expects profit growth for the S&P 500 to slow to 6.5% for all of 2007, analysts expect the pace to rebound in 2008 back into double digits, with an 11% gain. So the outlook for a soft landing followed by another growth surge remains intact.

In the short term, some investors say expectations have come down too far for the first quarter.

"It's a low hurdle now," says James Paulsen, chief investment strategist with Wells Capital Management. "If we do 6% growth, that's 50% upside to expectations, so there are some opportunities out there."

Industrial giant

Alcoa

(AA) - Get Report

will kick off the reporting season after Tuesday's closing bell. Analysts expect the aluminum company to report earnings, before items, of 75 cents a share, up from the 70 cents a share it logged for the same quarter last year.

On Friday, conglomerate

General Electric

(GE) - Get Report

will weigh in, providing another broad view of economic conditions.

Almost every sector saw its earnings estimates come down on Wall Street during the quarter, but the largest declines came from the energy industry, an area that was largely responsible for the extraordinary strength of recent years.

Currently, analysts predict a profit decline of 2% for the energy sector, down sharply from expectations at the beginning of the year for 13% growth, as oil prices swung wildly in the quarter.

Analysts project a 10% decline in earnings for the consumer discretionary sector, which is expected to be the weakest area of the economy. Most of that weakness comes from struggling U.S. automakers such as

Ford

(F) - Get Report

--

General Motors

(GM) - Get Report

is expected to post a slight increase in operating earnings -- as well as homebuilders such as

KB Home

(KBH) - Get Report

and

Lennar

(LEN) - Get Report

as they muddle through the slump in the U.S. housing market.

The strength will come from technology, which is expected to lead gains with a 10% profit increase, helped by strong earnings growth from

Microsoft

(MSFT) - Get Report

following the rollout of its new operating system.

Another standout performance is expected from the financial sector, where the ongoing frenzy of mergers and acquisitions is resulting in a windfall for the nation's largest investment banks and brokerages.

Goldman Sachs

(GS) - Get Report

and

Morgan Stanley

(MS) - Get Report

have already reported strong first-quarter results, and

Merrill Lynch

(MER)

is expected to report quarterly earnings that more than quadrupled from last year's results.

The financial sector is expected to show a 7% jump in earnings overall for the quarter. Excluding the nation's seven largest investment banks and brokerages, the industry is expected to show a mere 1% uptick.

Elsewhere, investors are counting on a strong job market to keep consumers afloat and pick up the slack.

"We're entering an economic valley," says Stovall. "The market is looking beyond the valley."