Investors are about to find out if the economic woes in Europe are going to deliver a deep wound to U.S. company earnings instead of the mere scratch that many expect.
The fourth-quarter reporting period kicks off next week, and all eyes will be on erosion in sales in Europe, where the debt crisis has propelled the region toward a recession. This could dent positive sentiment just as investors start to focus on strong U.S. growth.
Analysts believe that low U.S. stock market valuations already factor in weakness from Europe for the fourth quarter, but there are concerns that earnings forecasts for 2012 have yet to account for deeper fallout.
"There's some unhealthy optimism that thinks somehow the U.S. can decouple from the rest of the world," said Shawn Hackett, president at Hackett Financial Advisors in Boynton Beach, Florida. "That is highly unlikely."
Companies including tech heavyweights Texas Instruments and Hewlett Packard and others like insurer MetLife have already cited fallout from Europe for reduced expectations. Analyst forecasts for fourth- and even first-quarter earnings have tumbled since the summer despite steady improvement in U.S. economic demand.
While all 10 S&P 500 sectors have seen profit estimates cut, materials and financials have been the hardest hit. Other sectors that could get dragged down by Europe's problems include the industrial, consumer and technology sectors.
The overall S&P 500 forecast for fourth-quarter earnings growth has already been slashed, down to growth of 7.9 percent from 17.6 percent previously.
Some 14 percent of all Standard & Poor's 500 company sales come from Europe, which would have a sure impact on results, said Standard & Poor's earnings analyst Howard Silverblatt.
"In earnings, when you're talking about pennies beating it or not, 14 percent of the number makes a difference."
The euro zone debt crisis has engulfed much of the continent as major institutions have found themselves exposed to debts in struggling nations such as Greece, Portugal, Italy and Spain. The latter two are the third- and fourth-largest economies in the euro zone and are struggling to reduce debt through severe spending cuts and higher taxes.
These problems are affecting economic growth. Italy grew just 0.2 percent in the third quarter from the previous year. Economists in a December Reuters poll forecast the euro zone will contract by 0.3 percent in the fourth quarter, followed by a further 0.2 percent contraction in January-March, before a meager recovery in subsequent quarters.
Global companies with more than 50 percent of their sales in Europe and with a market cap greater than $5 billion underperformed other major averages in 2011, according to Thomson Reuters data.
An index of 161 names meeting that criteria lost 13 percent in 2011, compared with a 5 percent drop for the MSCI World Index. Cisco Systems, which gets 56 percent of sales from Europe, is the largest U.S. name in this group.
Many other U.S. companies have less exposure to Europe than Cisco, but still generate a substantial portion of their sales - 20 to 30 percent - there. In these cases, it would take a more severe recession to hurt their revenues.
In a report on Thursday examining a number of industrial equipment companies, Morgan Stanley analysts pointed out that many executives were "cautiously optimistic" with expectations for a mild recession in Europe. Companies in that industry are expecting 4 to 6 percent revenue growth in 2012, but Morgan Stanley said "short-term trends" suggest estimates could fall short of that if world growth slows.
"If we're dealing with organic revenue growth, you're going to be seeing earnings declines," said Hackett.
"In some cases, in the more cyclical businesses, it could be very severe, and I do not believe the stock market has priced in what the likely reality is."
Google's stock on Thursday was downgraded by brokerage Benchmark Co, whose analysts expect Google to suffer a decline in European advertising revenue.
PROFITS EYED FOR REBOUND
A drumbeat of negative preannouncements is also raising some concerns.
The ratio of negative to positive preannouncements over the last four weeks is at 3.3, and it hit a 10-year high late in December. The long-term average is 2.3, according to Thomson Reuters data.
"The number of companies issuing negative guidance during the fourth quarter has increased, and this perhaps has flown a little under the radar screen over the last few weeks in our judgment," Morgan Stanley analysts wrote in a 2012 outlook. The firm expects the S&P 500 to end 2012 at 1,167, which would be an 8.8 percent decline from the current level.
The euro zone's weakness has another detrimental effect. Strength in the dollar against the euro will increase headwinds for earnings, because it makes U.S. goods more expensive in Europe.
"Each 1 percent appreciation in the U.S. dollar corresponds to an expected 0.97 percent decline in aggregate earnings," Morgan Stanley wrote.
Still, many stock strategists are hoping healthy sales from the United States, where the economy is slowly improving, will more than offset the negative impact of Europe.
"Europe is clearly the caboose on the train...(but) I don't think the caboose is as bad as most people think it is," said Ken Fisher, a billionaire investor whose money management firm oversees $40 billion in assets.
"At a time when people have been fearful of a weak Europe, the economy in America has been consistently stronger than people have though it would be," he added.
Several blue-chip companies with heavy exposure to Europe performed well in 2011. McDonald's, for instance, derives 42 percent of its sales from Europe, and it was the Dow's best performer last year, rising 31 percent.
Kraft Foods generates 32 percent of sales in Europe, and its stock rose 19 percent in 2011. And Apple gets 26 percent, according to Thomson Reuters data, and its stock was up 25.6 percent.
Those gains would be in danger if Europe's fundamentals worsen.
Big-cap multinationals have "become a bit of a darling here in the last couple of months...they're probably more vulnerable to disappointments," said James Dailey, portfolio manager of TEAM Asset Strategy Fund in Harrisburg, Pennsylvania. (Reporting By Caroline Valetkevitch; Editing by Leslie Adler)