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How a "profits recession" could slam the economy

While central bankers got all the attention last week -- from the Federal Reserve acknowledging the risk of too-low inflation from the crude oil wipeout to the Bank of Japan cutting rates below zero -- investors remain preoccupied with earnings.

Heading into the fourth-quarter earnings season, the S&P 500 was on track for its third consecutive profits decline. That hasn't happened since the recession ended. And it's primarily being driven by the drag from low oil prices as well as the negative impact on foreign earnings from the strong dollar. Turmoil in China is also getting a lot of blame.

So far, the earnings results have been pretty poor. And that's a big risk to the economy.

According to FactSet data, with 40 percent of S&P 500 companies reporting, 72 percent have posted better-than-expected earnings, while 50 percent have reported better-than-expected revenues. Yet overall earnings are expected to decline 5.8 percent from last year. Companies in the energy and materials sectors are the worst off.

Still, hope dies hard: Analysts expect revenue growth to return in the current quarter and earnings growth to return in the second quarter.

Whether the situation turns around depends largely on whether oil prices can stabilize. Investors seemed primed for positive news when rumors of a possible OPEC-Russia supply cut lifted crude oil futures last week. And just look at what happened to Chevron (CVX) on Friday: Shares gained 0.6 percent after being down 3 percent in premarket trading following a big quarterly loss.

A lot of bad news has already been priced into stocks. So, if the energy sector can get some relief, the overall market will as well. Ed Yardeni of Yardeni Research noted that S&P 500 earnings fell 14.1 percent in third-quarter 2015 over third-quarter 2014. But that becomes a 3.4 percent rise in earnings when the energy sector is removed.

The turnaround will need to happen soon. History shows that corporate profits tend to drive the ups and downs of the business cycle. Profitable companies increase advertising spending, raise capital investment, hire new workers and hike pay to poach talent from other companies. Unprofitable companies shrink.


The chart above shows how the decline in forward earnings growth since crude oil peaked in 2014 has already had a negative impact on real capital spending. Thus, it's no surprise fourth-quarter GDP growth slowed to a 0.7 percent seasonally adjusted annualized growth rate from 2 percent in third quarter, missing estimates of a 0.8 percent gain.

The good news: The latest data shows forward earnings growth has pushed back into positive territory. With oil prices closing the week near $34 a barrel, up from a low of $27.56 seen earlier in January, let's hope the profits turnaround can continue.

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