Another Earnings Season, Another Flat to Down Market?

The stock market has been essentially flat since 2011 trading got underway, and if recent history is any guide it won't do much during fourth-quarter earnings season, either.

Dow component and aluminum giant Alcoa (AA) unofficially kicked off the reporting period late Monday with another mixed release (earnings came in above Wall Street's forecast but sales fell short), and stocks posted muted gains the following session.

Partly that's due to a V-shaped recovery in corporate earnings based on wider operating margins (also known as cost cuts) rather than any rebound in revenue. Pretty soon the old saying "you can't cut your way to growth" will catch up with companies' bottom lines.

"While companies have been producing strong double-digit earnings gains on the back of single-digit revenue growth coupled with significant cost reductions over recent quarters, further gains are limited," Jeffrey Kleintop, chief market strategist at LPL Financial, writes in his latest report to clients. "There is little room to squeeze out additional expenses in 2011 particularly given that costs associated with materials, energy, and expanding workforces are rising."

On Pace for Record Earnings Per Share

The good news is that the S&P 500 ($INX) may set a record this season for notching the highest fourth-quarter earnings per share in history. Indeed, if the numbers come in as expected, the current earnings season may be among the top three of all time, Kleintop notes, trailing only the first and second quarters of 2007. The bad news is that having climbed back to near their prior peak, earnings growth is beginning to slow, Kleintop says.

"We except closer-to-normal EPS growth of 10% in 2011 after 2010 resulted in a strong 39% gain over 2009," the strategist writes. "Our outlook for 2011 corporate profits is bound, in part, by continued sluggish revenue growth resulting from modest economic expansion in the developed markets, including the United States."

Perhaps that explains why the market has been such a dog during the last four earnings reporting seasons. The S&P 500 gained about 13% last year, but it didn't get much help while companies were releasing results. The broader market was actually unchanged or lower for all four of 2010's earnings season, Kleintop notes. See the chart below, courtesy of LPL Financial.

The mid-January through mid-February season coincided with a peak-to-trough drop of 7%, Kleintop notes, while the mid-April to mid-May period coincided with a decline of about 10%. The mid-July to mid-August season saw a slight decline, and the mid-October to mid-November season notched a slight gain.

"It is important to keep in mind that the companies that report early in the season are most often not the bellwethers they are commonly thought to be," Kleintop says. "We will not really know how results are shaping up until just after the end of the month when about half of the S&P 500 companies will have reported."

Still, given the fundamentals and the technicals (bullish sentiment and overbought market conditions), the current reporting season could once again coincide with a flat-to-down market. So what's an individual investor to do?

"Use any weakness as a buying opportunity," Kleintop suggests, "which may be capable of enhancing the modest single-digit gains we envision for the year as a whole."