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Earnings season will be awful — Here are 2 reasons why you shouldn't panic

Sam Ro
Managing Editor

Earnings season kicks off this week with about 8% of the S&P 500 (^GSPC) revealing their financial results for the three months ending in March.

And expectations are for a huge plunge in profits.

“For Q1 2016, the estimated earnings decline is -9.1%,” FactSet’s John Butters said. “If the index reports a decline in earnings for Q1, it will mark the first time the index has seen four consecutive quarters of year-over-year declines in earnings since Q4 2008 through Q3 2009.”

The companies expected to see the biggest drops in earnings are in the energy and materials sector, where low commodity prices have crushed profit margins. Also lagging is the financials sector, where activity has been very weak. Another sector exhibiting weakness is the industrials, which has been getting squeezed by the strong dollar and slowing demand overseas.

S&P 500 earnings are forecast to fall 9% in Q1. (Image: Factset)

While all of that is not encouraging, it may be a mistake for investors to drop everything and run for the hills.

First of all, the bar is set low

It's not news that earnings are expected to drop. If anything, any bad news is already priced into the market.

But in recent months, analysts have been particularly cautious, cutting their forecasts for earnings at an unusually aggressive rate.

“Consensus expectations were slashed 9% over the last three months—more than double the typical pre-EPS season cut,” Bank of America Merrill Lynch’s Savita Subramanian observed. “All ten sectors saw downward revisions, led by Energy.”

Analysts have been slashing EPS estimates at a high rate (Image: RBC)

“While forecasts typically fall going into reporting season, the pace of this decline was particularly steep,” RBC’s Jonathan Golub acknowledged. “We believe that the Jan-Feb selloff was the primary driver, rather than weaker data.”

In other words, the bar has been set very low, which has analysts thinking that companies will have an easier time beating those expectations.

“A bigger beat this quarter seems reasonable given this year’s dollar weakness, rebound in commodity prices, improvement in the ISM and other industrial indicators, and the improvement in global growth,” Subramanian said.

So, while you should expect to hear that earnings fell, don't be surprised if the decline isn't as steep as expected.

Second, the worst may be over

To Golub and Subramanian’s points, it’s worth remembering that these Q1 earnings we’re about to see are backwards looking, and the more recent economic data point to a pickup in activity.

“As a result of 1Q's prospects, full-year 2016 consensus expectations remain subdued,” UBS’s Julian Emanuel acknowledged. However, he noted that earnings growth should come back in the second half “commensurate with the end of the Oil and FX drag and the prospective reacceleration of the US economy to a growth trajectory in excess of 2%.”

Higher oil prices and a weaker dollar could fuel earnings growth in the second half of the year. (Image: UBS)

Deutsche Bank’s Torsten Slok  agrees with this assessment.

“With the big fall in oil and big dollar appreciation behind us and with manufacturing ISM rebounding there are good reasons to believe that the slowdown in S&P500 earnings is temporary and we should over the coming quarters see a rebound is overall earnings,” Slok said in an email on Sunday.

“So yes, earnings have been slowing but given the turnaround in oil and the dollar, earnings are likely to accelerate again over the coming quarters.”

Aluminum giant Alcoa (AA) unofficially kicks off earnings season on Monday after the closing bell. Analysts estimate earnings fell to $0.03 per share from $0.04 in Q4 and $0.28 a year ago due to lower alumina prices.

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Sam Ro is managing editor at Yahoo Finance.

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