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Why profits won't plunge

April 12, 2012: 6:00 AM ET

Earnings growth is slowing, but it's not going to disappear.

Fortune -- Aloca (AA) may be more than a one-off.

The recent downturn in the market has been fueled mostly by a growing fear that corporate earnings growth is tapped out. The string of stock drops snapped on Wednesday after the giant metal producer said it made money in the first quarter. Analysts had been expecting a loss. The question is whether surprises like this will be a trend.

It's true that it's likely the double digit earnings growth of the past few years is likely to slow. Recession bottom lines were easy marks. Showing growth is getting tougher. What's more, corporate profit margins are at multi-decade highs. And revenues growth remains sluggish. But have analysts and investors grown too pessimistic too soon? That might also be true.

4 Key Signs to Watch This Earnings Season

Analysts now expect earnings growth for the companies in the Standard & Poor's 500 (SPX) in the first quarter to be the grand total of zero, down from a 19% jump in the first three months of last year. It's likely, though, that actual earnings growth will come in stronger than nada. First of all, analysts are known to low-ball. Nearly 70% of companies typically beat expectations. Just factor in the normal surprises and, according to FactSet's earnings expert John Butters, profit growth will be more like 3%. But the earnings jump could be even higher than that. While it's still early, more than 90% of all S&P 500 companies have yet to tell investors what they made in the first quarter, so far surprises have been running higher than usual. Nearly 80% of the companies that have reported have had better than expected earnings. And companies appear to be beating expectations by more than usual - 7% this quarter, compared to 3.7% in the fourth quarter.

Second, in general Wall Street economists expect the economy grew 2% in the first quarter, before inflation. Inflation is running at nearly 3%. Analysts are also expecting profit margins to rise another 1%. Add that all up and you get profit growth of about 6%. Not great, but far higher than zero.

Lastly, some have been arguing that the reason corporate profit growth is slowing and margins will fall is because companies are hiring again. But there's a flaw in that argument. Hiring may indeed increase expenses. But if more companies hire, enough to dramatically raise expenses, then it's likely the big jump in employed people will boost the economy, creating more sales and profits for the companies that are hiring. What's more, the whole point may be moot. Last month, it appears employers slowed hiring again.

Here's the weird thing. Go out a few quarters and Wall Street analysts still appear to be unreasonably bullish. Analysts are still predicting that earnings will grow 16% in the fourth quarter. That's probably not going to happen. It's likely that we have reached our peak in earnings growth. But a no-earnings growth recovery? I wouldn't bet on that either.

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About This Author
Stephen Gandel
Stephen Gandel

Stephen Gandel has covered Wall Street and investing for over 15 years. He joins Fortune from sister publication TIME, where he was a senior business writer and lead blogger for The Curious Capitalist. He has also held positions at Money and Crain's New York Business. Stephen is a four-time winner of the Henry R. Luce Award. His work has also been recognized by the National Association of Real Estate Editors, the New York State Society of CPA and the Association of Area Business Publications. He is a graduate of Washington University, and lives in Brooklyn with his wife and two children.

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