Wall Street’s biggest fear could be earnings, not China by Stephen Gandel @FortuneMagazine September 3, 2015, 7:34 AM EDT E-mail Tweet Facebook Linkedin Share icons The market’s profit pothole may not be as big as it seems. China, and its economic slowdown, has been the biggest worry among U.S. investors for the past few weeks. But a number of market watchers say another slowdown should be worrying U.S. investors more, and it’s happening right in our backyard, in U.S. corporate profits. Profits of companies in the S&P 500 are expected to drop 4.3% this quarter from a year ago, according to market data company FactSet. That would be the biggest drop since the third quarter of 2009, when the economy was still clawing its way out of a recession. It would be the first time earnings have fallen more than 1% in a quarter since the end of the recession. And it would also be the first time since the end of the recession that profits dropped for two quarters in a row. Earnings are expected to have fallen 0.7% in the second quarter. (About 10% of the companies have yet to report last quarter’s profits.) Earnings, particularly expected earnings, play a major role in how investors value stocks. And a drop in overall corporate profits is rare when the economy is growing, as it is now. Such a dip may mean the economy’s growth may be coming to an end as well. But the current economic expansion has weathered profits dips in the past. The earnings of the companies in the S&P 500 fell 1% in the third quarter of 2012. The last few years have been a particularly slow one for U.S. profit growth. That is, in part, because profits zoomed in the recession’s aftermath. This has made it hard for companies to keep up in subsequent years. Also, profits margins have been at record highs for a while, making it more challenging for companies to squeeze any more money out of their sales. Couple that with the fact that the economy has been growing pretty slowly, with very little inflation, making it hard for companies to raise prices. A rising dollar hasn’t helped either, hurting foreign sales. The result has been slim profit growth that has generally stayed in the single digits and, at times, even slipped into negative territory. This quarter’s slip into the red may not end up being that all that big. At the end of last quarter, analysts were expecting earnings at the average company in the S&P 500 to drop 4.6%, a bigger decline than the current projected fall, according to FactSet’s figures. Many companies ended up beating those estimates. And that’s typical for Wall Street. Analysts like to set the bar low. In any given quarter, typically two-thirds of companies beat their projections. With one month left in the first quarter of 2015, earnings were projected to drop 3.9%. In the end, profits rose 1% in the first quarter. What’s more, FactSet says that 72% of companies that have pre-announced their earnings for this quarter have told investors to expect less than previously thought. (Again, that figure is always pretty high, because companies with bad news try to drive down expectations.) In the first quarter, 84% of companies that gave pre-announcements offered negative news. So it’s likely that third quarter earnings won’t yield nearly as big a drop as projected, if at all. What’s more, all of the projected current earnings drops and then some come from one sector—energy. Industry-wide profits are expected to drop 62% in the third quarter. Without the energy companies, profits for the companies in the S&P 500 are supposed to increase by an average of 2.3%. That’s not great news, particularly at a time when stocks are trading at fairly high multiples. The average company in the S&P 500 has a price/earnings ratio of 17, based on future earnings. That’s higher than the 14 p/e that stocks have been trading on average for the past 15 years. But earnings growth has been low and uneven for a while. So investors have likely priced that in. Earnings growth may not get any better this quarter, but it won’t get significantly worse either.