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3 scariest things about this disappointing earnings season

October 25, 2012: 11:35 AM ET

The Fiscal Cliff might be the least of our problems.

FORTUNE -- The cliffs are piling up.

You've heard about the Fiscal Cliff. Even if we get through that, though, there appears to be another nasty drop that the market will have to deal with. Earnings. And in the last week, that cliff has been looking steeper and steeper.

We're about halfway through the third quarter earnings season, when companies say how they did this summer. So far the reports in general haven't been upbeat. Top strategist Rob Arnott back in March made the case to me that earnings growth was bound to slow. (I had my doubts.)

Now Arnott looks sage-like. S&P estimates earnings of the 500 companies in their index fell 3% in the third quarter from a year ago. That would be the first drop in corporate profits since the end of the recession.

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There are two ways to see that stat. Earnings growth has been phenomenal this recovery, and the third quarter a year ago was a record for the S&P 500. So the fact that we are slightly off the peak isn't too bad. What's more, analysts expect earnings in the fourth quarter to rebound sharply, up nearly 10%. So this is just a blip.

The other way to see it: Watch out below. Unfortunately, I see three reasons it could be the latter.

First of all, it's very rare for corporate profit growth to turn negative. When it does, it's usually because we are in a recession or headed for one. For instance, corporate profit growth turned negative in the third quarter of 2007. The last time it was negative before that was in 2001. Before that, you basically have to go back to 1989.

There is one quarter in 1998 when profit turned negative, and then bounced right back. But that's the one exception in the past 25 years, and it was closer to the end of that bull market than the beginning.

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Second, profit margins, already at all-time highs, look tapped out. Companies have benefited, in a way, from a slow economy that's meant they didn't have to add a lot of workers, or hand out raises. Eventually, that's going to change. When it does, lots of other costs are likely to rise as well including energy and materials.

Of course, it's natural for profit margins to shrink at this stage in a recovery. That's what happens. And some have argued that we can have strong earnings growth with a return to normal profit margins. But to do that you have to have strong economic growth. And we don't.

Third, economic growth continues to be weak, and it's looking weaker. A number of economists have been pulling down their GDP growth estimates, many of which were below 2% to start with. And while the U.S. might get better after the election, there's no real reason to think that it would change things in Europe or China.

Given all these risks, you would expect the stock market to be cheap. Stocks have risen a lot this year, confounding a number of smart hedge fund managers, who have sat out this rally. And you can say the smart money is always a lot dumber than it gets credit for. But you can't say their fears about where stocks are headed are unfounded.

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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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