Wall Street Faces Profit Recession as Earnings Season Begins

Wall Street's fourth-quarter earnings season that gets under way next week could confirm something many investors may not want to hear: the U.S. economy may be doing well but corporate profits are in a recession.

An earnings recession - two quarters of declining profits - would be led by the usual suspects, energy and materials companies. But its severity may depend on consumer discretionary companies, which have been warning about profits at an unusual pace.

Consumer discretionary companies, which led S&P 500 gains in 2015 and have had the second-highest average profit growth rate of any sector over the last five years, are more pessimistic than usual going into the quarter. That is despite the benefit of lower gasoline prices for consumers.

Consumer discretionary stocks rose 8.4 percent last year, thanks in large measure to Netflix and Amazon.com, the year's best S&P performers.

While consumer discretionary fourth-quarter profits are forecast to be up 8.4 percent, that is below the 13.6-percent growth that was forecast only three months ago, according to Thomson Reuters data.

Twenty-five companies in this sector so far have warned and none gave positive guidance, the highest number of negative forecasts since at least 2006, according to FactSet. In a typical fourth quarter, only two-thirds of earnings pre-announcements in this group are negative.

By comparison, overall 85 S&P 500 companies guided below analysts' estimates for the quarter and 26 issued positive guidance, roughly in line with recent quarters, FactSet data showed.

Macy's this week cut its earnings outlook for the second time and blamed a fall in sales on unusually warm weather that kept consumers from buying coats. It also cited the strong dollar.

Companies that have warned also include L Brands, GameStop, Starbucks, Target and AutoNation. Specialty retailers have given the most negative guidance, while 17 companies in the sector have cited the strong U.S. dollar as a reason behind the lowered outlooks, FactSet said.

As earnings forecasts come down, some strategists say the expected boost to consumer spending from lower energy prices may have been overblown. Consumers still have debts to pay down.

"The thing behind the consumer not spending despite what looks like tailwinds from lower energy price (is), people are still deleveraging from prior to 2008," said Robert Pavlik, chief market strategist at Boston Private Wealth in New York. "The consumer is still being weighed down."

EARNINGS RECESSION?

Overall, S&P 500 earnings are forecast to have dropped 4.2 percent in the fourth quarter. That would be their second-straight quarterly decline, Thomson Reuters data showed, which would meet the common definition of a profit recession.

Revenues are expected to be slightly less bad - with only a 3.2-percent decline expected, since profits can be lifted by stock buybacks, cost cuts and other maneuvers.

When final reports are tallied, S&P 500 companies are expected to show zero profit growth for all of 2015. Profit growth of 7.5 percent is forecast for 2016, but that estimate has also fallen since Oct. 1, when it stood at 10.3 percent.

The energy sector is expected to be the biggest drag on S&P 500 results as oil prices continue an almost relentless decline that began in mid-2014. The materials sector is also expected to show a double-digit profit drop, hit by a downward spiral in other commodities.

Goldman Sachs on Thursday lowered its earnings-per-share forecast for 2015, 2016 and 2017, saying energy was the main reason behind the revisions. It expects the sector to post an annual operating loss for 2015 for the first time since its data began in 1967. Goldman Sachs also cited the slowdown in China and signs that profit margins have peaked.

That could be bleak news for the stock market, which posted a slight loss for 2015 and has been battered at the start of 2016 by a China stock selloff and growing concerns over a global economic slowdown. Major indexes lost about 6 percent last week, the worst start to a year since records were kept.

Even with the selloff, valuations are stretched. The S&P 500 trades at 15.7 times forward earnings, well above its 10-year median of 14.7, according to Thomson Reuters data.

"We go into fourth-quarter results and energy is still getting obliterated. Which are going to be the leadership groups? My worry is they're not going to materialize," said Daniel Morgan, senior portfolio manager at Synovus Trust Company in Atlanta.

(Reporting by Caroline Valetkevitch; Editing by Linda Stern and Nick Zieminski)