In June, as the third quarter got underway, consensus profits for companies in the S&P 500 were expected to show a modest 1% year-over-year dip. Three months later, analysts now think profits will slide nearly 5%, from year-earlier levels. 

Of the companies that have announced guidance, 76 expect negative EPS growth for the third quarter according to FactSet Research. That compares to only 32 companies that have issued positive guidance for the three-month period so far. 

The pain continues to build in the energy and materials sectors, but many other sectors are seeing downward earnings revisions as well. Fear of higher interest rates and declining earnings growth led an 8.6% drop in the S&P 500 index, and a sharp spike in the VIX volatility index since mid-August.

The trend is so bad that analysts are expecting earnings growth of just 0.6% in the fourth quarter. The revenue picture is equally challenging.

Analysts think that third-quarter sales fell 3.3% against the same quarter last year. On a full-year basis, they are modeling for a 2.4% drop in sales. Unless revenue growth returns soon,  investors may start questioning whether corporate management teams can squeeze further earnings growth from continued cutbacks.

The 12-month forward price-to-earnings ratio for the S&P 500 stands at 15.2, which is above both the five-year and 10-year average. Even as stock prices have come down, expectations for forward earnings have fallen even further, leading to higher forward multiples. Weak earnings reports in the third quarter, and an even weaker outlook by management could, send this market into a tailspin.

Two Sectors Stand Out In A Sea Of Red
Amongst all the bad news , the Telecom Services and Consumer Discretionary sectors are expected to report the largest growth in earnings across ten sectors. The Telecom Services sector is the only one to see an improvement in earnings expectations since June, with expectations rising to a 17.6% increase in year-over-year earnings per share.

Despite strength in telecom, the iShares US Telecommunications ETF (NYSE: IYZ) has fallen 8% this year and trades for 17 times trailing earnings. The fund invests in 25 of the largest telecom players in integrated telecommunications (47%), wireless telecom (31%) and alternative carriers (20%). AT&T (NYSE: T) accounts for 11% of the fund and is expected to post 8% growth in year-over-year earnings. The recently completed merger with  DirecTV should provide a further profit boost.

Shares of the telecom fund pay a 2.5% yield, and the dividend appears poised to grow, thanks to strong earnings across the sector. Sales for telecom companies are expected to rise 8.6% this year, the strongest growth of any sectors. Consolidation in telecom and cost savings continues to be a strong theme and should keep valuation strong into 2016. 

Stocks of consumer discretionary companies are expected to post 10.3% earnings growth with 12 of the sector’s 31 industries on pace to record double-digit growth. Expectations for growth of 4% in holiday sales have been relatively subdued, but could get a boost from lower prices at the pump and economic growth that has surprised to the upside. Wages look like they are finally following the economy higher and consumers should drive sales of retail establishments through the rest of the year. 

Car and truck manufacturers continue to drive consumer sales with expectations for 52% earnings growth in the third quarter compared to last year. The average age of cars on U.S. roads increased to a record 11.5 years in July, driving demand for replacement vehicles, and low rates should keep sales surging higher for the industry well into next year. Internet retailers are expected to post a 41% increase in Q3 earnings compared to last year, a very good sign ahead for the all-important Q4 shopping season.

The Consumer Discretionary Select Sector SPDR ETF (NYSE: XLY) has risen a 6.3% this year and trades for 20 times trailing earnings. The fund holds shares of 90 companies with the largest weights in media (24%), specialty retail (20%), internet retail (15%) and apparel (8%). 

This fund pays a 1.4% yield with the trailing dividend of $1.08 per share increasing by 19% over the same period last year. Sales for consumer discretionary companies are expected to rise 3.4% this year, the fourth highest of the ten sectors and with room for an upside surprise on the heels of a strong holiday shopping season.

Risks To Consider: General market sentiment could drag telecom and consumer discretionary down with it even if the trend in earnings remains positive. Moreover, global economic weakness could eventually lead to lower growth here at home, which would crimp consumer spending.

Action To Take: Sales trends and earnings in the Telecom and Consumer Discretionary sectors appear set to beat the general market negativity this quarter and could see shares rise on positive management outlooks for the rest of the year. 

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