Earnings season begins in earnest when large banks such as JP Morgan Chase & Co. (JPM - Get Rating) Morgan (JPM) and key companies such as Netflix (NFLX)  and IBM (IBM) reporting third-quarter results next week.

With stocks stalling just below all-time highs and essentially where they were 18 months ago, the next few weeks could make or break whether the market can finally establish a new and sustainable bull leg higher, or rollover into a potential bear market.

Right now, with data suggesting a global slowdown is taking place, and tariffs beginning to take a bite out of profits, the outlook is fairly pessimistic.

Consensus estimates from analysts are looking for a third consecutive quarterly decline in corporate profits. This would match the late 2015-early 2016 ‘”earnings recession” which saw stock sink by over 20% during the first part of 2016.

But while the trend is not necessarily promising, we need to remember Wall Street typically responds to whether a company meets, beats, or misses on expectations.  So, the fact that expectations have been coming down. In fact, this quarter has seen the largest number of negative preannouncements since that 2015 period — stocks may actually be able to rally if things are not as bad as expected.

But, what may be of greater concern is the outlook or guidance that companies provide.  That had taken on a decidedly negative tone over the past few quarters — you can see the steep drop in the use of optimistic language during earnings calls—and it’s likely to get worse as the potential for a resolution with China over trade diminishes.

(Source: Factset)

There is also the issue of the quality of the earnings coming from U.S. companies as they diverge not only from the rest of the world, but also from certain standard measures of profitability.

As you can see, U.S, corporate earnings have far outpaced the rest of the global economy as measured by the MSCI All-Country Index.  One has to wonder, given how reliant many U.S. companies on overseas demand — 65% of S&P 500 revenues come from abroad —  how U.S. profits can continue to diverge.

Another concerning divergence is if we view profits through the National Income and Profit Accounts (NIPA) which have stagnated during the post-crisis decade. By contrast, the S&P 500’s profits under GAAP accounting rules, leaving plenty of room for creative accounting, have moved higher.  And stock share prices have risen far faster than both.

There is normally some disparity between the two measures as companies will often use some financial engineers to smooth results during more difficult periods. The recent and accelerating divergence seems unsustainable and suggests U.S. corporate profits are not as strong they appear.

This quarter’s earnings season may force them, and investors, to acknowledge earnings projections and extension stock prices, need to come down.

JP Morgan Chase & Co. (JPM - Get Rating) shares were trading at $112.52 per share on Tuesday afternoon, down $1.85 (-1.62%). Year-to-date, JP Morgan Chase & Co. (JPM - Get Rating) has gained 18.86%, versus a 17.74% rise in the benchmark S&P 500 index during the same period.

About the Author: Steve Smith

Steve has more than 30 years of investment experience with an expertise in options trading. He’s written for TheStreet.com, Minyanville and currently for Option Sensei. Learn more about Steve’s background, along with links to his most recent articles. More...

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