Profit reality: 2017 rebound won't match hopes

Third-quarter earnings season hasn’t even started yet. But forward-looking investors are already warning that upbeat profit forecasts for next year are too optimistic, creating a vulnerability for a stock market already struggling under the weight of pricey values.

When aluminum maker Alcoa kicks off the third-quarter earnings season Tuesday, Wall Street will be watching to see if the Standard & Poor’s 500 index can post positive earnings growth and avoid its fifth straight quarter of declines. Analysts are currently forecasting S&P 500 profits to drop 0.7% in the July through September span.

And while it’s important for earnings to turn positive now to justify lofty stock prices, what CEOs say about the prospects for 2017 could be even more important, as investors have been pushing up stocks for most of 2016 on the belief that earnings will improve dramatically next year. If the 13.9% growth Thomson Reuters says is currently forecast for 2017 doesn’t materialize and analysts have to trim their forecasts, some investors might be unwilling to wait for improvement.

“Equity investors usually look out two to four quarters, so the 2017 outlook takes on added importance,” says Nick Sargen, senior investment adviser at Fort Washington Investment Advisors. “Wall Street's earnings forecasts are way too high, and I expect the standard ritual of them being scaled back."

And if they do, investors could be in for some heartburn.

“The risk,” says Bruce Bittles, chief investment strategist at Baird, “is that earnings fail to meet expectations. If earnings fail to come through the markets could be vulnerable.”

Indeed, there’s a dual risk this earnings season. A flat-out poor third-quarter and a continuation of the earnings recession. Or an upside surprise for third-quarter results, but “bad corporate guidance,” says Michael Farr, president of Farr Miller & Washington. “That could take share prices lower,” he says.

In a sign of the lofty expectations for 2017 earnings, Scott Wren, senior global equity strategist at Wells Fargo Investment Institute, sees full-year 2017 profit growth closer to 6% to 7% — or roughly half the current market consensus.

Some factors that could cause corporate profitability to bounce back more slowly than forecast is the fact the Federal Reserve and other central bankers are having a more difficult time moving the economic needle with their stimulus policies. What’s more, the odds are more than 50-50 that the Fed could hike interest rates in December, with the prospects of more hikes coming in 2017.

Another potential drag on earnings is a hit to profit margins, which could come under pressure as labor costs rise, interest rates move higher and companies move to boost spending that they have put off, Farr says.

Still, some Wall Street pros argue that even a return to earnings growth next year, albeit lower than the lofty projections, is enough to support stock prices.

“If earnings grow in 2017 then stocks can move higher,” says David Joy, chief market strategist at Ameriprise Financial, adding that the first step needed is for earnings to show “incremental improvement” in the third quarter and fourth quarter of this year.

A profit rebound in the energy sector, which has dragged down overall S&P 500 profitability in the past year, is key to the improving profit picture next year, adds Joy. Other drivers include a stabilization or dip in the value of the U.S. dollar, which would make U.S. companies more competitive abroad, as well as overall strength in the global economy.