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What to Look for in Third-Quarter Earnings

As corporate earnings come rolling in, keep an eye on these issues to see how the economy is really performing.

Jeremy Glaser, 10/10/2011

Third-quarter earnings start in earnest next week, and all signs point to another quarter of respectable corporate profits. And if these expectations are met, it will be a relief for investors who have been bombarded with bad news recently.

In fact, corporate profits have been one of the few true bright spots during the economic recovery. During the height of the recession, firms did a great job of cutting costs to the bone in order to survive the worst of the downturn. As demand crept up from its lows, many businesses discovered that they could build the same amount of widgets with fewer people, so they choose not to hire. This has kept unemployment elevated, but it's also kept margins sky high. Many U.S. firms have also benefited from exposure to fast-growing emerging markets. China, India, and South America have been demanding goods even as growth in developed markets remained anemic.

But can this winning streak continue indefinitely? With more clouds gathering over Europe and whispers of slowing growth in the emerging markets, it seems like there is a greater possibility that firms will start to miss expectations and see profitability slip. This is unlikely to be a sudden event, but here are some of the top issues I'll be looking closely at this earnings season to gauge the strength of corporate America. I'll circle back after the season wraps up to analyze whether things have improved or not.

Europe Woes
There haven't been many positive stories recently about the European economy. The sovereign debt crisis keeps growing, and key policymakers seem to just now be grasping the depth of the problem. There will be no easy fix, and large austerity cuts loom across much of the continent. But on the other hand, Germany and other major economies are still exporting lots of goods to the developing world, and unemployment remains low. Looking at results of companies that are either based in Europe or have significant European exposure should shed some light on whether consumers and companies are holding up.

U.S. Consumer
The economic news out of the U.S. hasn't been nearly as dire, but it hasn't been exactly rosy either. Even though payroll data was slightly better than expected this week, the job market continues to struggle, and the housing market remains stuck in the basement. However, the consumer in the United States hasn't completely fallen off the cliff, and there have been glimmers of hope in consumer spending data. Corporate earnings should give us a clearer picture of consumer spending behavior. Are people splurging on goods or just buying what they need to get by? Are consumers living paycheck to paycheck or feeling comfortable spending all month? These nuances can sometimes be lost in the aggregate data but can be telling about consumer confidence and what future spending patterns might look like.

Business Demand
Business confidence can be just as important as consumer confidence. If firms anticipate a sharp reduction in demand, they are going to pull back on spending and on crafting expansion plans. And it is the investment in new technology and the building up of inventories that can really drive the economic cycle. Parsing out businesses' stated plans for expansion and investment will be a good signal for where we are in the investment cycle.

Emerging Markets
Developing economies have been key drivers of many corporations' fortunes during the last few years. Getting a sense about how everything from luxury handbags to heavy equipment is selling in China and elsewhere should provide a window into how those economies are really performing. If there is faltering demand here, that would be a clear sign that the global economy is truly in trouble.

This one might seem somewhat obvious, but keeping track of how many firms are cutting their outlooks for both the short term and the long term is an important part of earnings seasons. The past few quarters we've seen a fair number of firms raise their forecasts for both the next quarter and for the remainder of the year as they are seeing business prospects improve. If management teams retrench a bit or cut expectations, that could indicate that things are truly slowing down.

Jeremy Glaser is the Markets Editor for Morningstar.com.

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