How to play it: Where are earnings surprises?

NEW YORK (Reuters) - This is the quarter the music is supposed to stop.

The earnings of companies in the Standard and Poor's 500 index are expected to drop three percent to $24.93 per index share over the third quarter, according to the consensus view on Wall Street. That is the first such decline in 11 quarters as companies run out of ways to cut costs.

Pessimists argue that falling profits will unplug the rally that sent the S&P 500 up 6.4 percent over the third quarter and nearly 14 percent for the year through Friday.

Some investors and analysts expect to make money by ignoring those expectations.

"We like to see lowered expectations because it's much easier when the bar is set low," said Ryan Detrick, senior technical strategist at Schaeffer's Investment Research.

Detrick is instead focusing on the companies and sectors that are the most likely to surprise investors this earnings season with sudden jumps or declines in share prices. Since 1994, 62 percent of companies have beaten estimates in a typical quarter, while 17 percent match and 21 percent miss, according to Thomson Reuters data.

It's a trend that looks like it will continue: Among the 34 companies that had reported through Friday, 59 percent had topped estimates and 24 percent were below.

Here are some ideas to help you find the next earnings champ.

SECTOR BETS

The energy sector is the market's reject. Earnings in the energy sector fell by 21 percent from the same time last year, the most of any segment of the economy, according to consensus estimates. After falling so far, Bill Stone, chief investment strategist at PNC Financial, expects the energy sector to offer the biggest positive surprise.

"I'm tempted to say the most-beaten down one will have the better chance of giving us a positive result," Stone said.

Better-than-expected margins will push earnings one percent higher than estimates overall - and many of these surprises will likely be found among energy companies, David Kostin, chief U.S. equities strategist at Goldman Sachs, said in an October 9 report to clients.

It's not a huge uptick, but analysts have raised their earnings estimates for the energy sector one percent since mid-July. Meanwhile, the price of Brent crude oil gained 10 percent during the same time, Kostin noted. The higher price of oil should benefit companies such as Exxon Mobil Corp, Chevron Corp and ConocoPhillips, he said.

Investors who want to take a broad bet on the energy sector could consider the $1.9 billion Vanguard Energy Index ETF, which is top-heavy with companies such as Exxon Mobil and Chevron. The ETF, which costs 19 cents per $100 invested and yields 1.5 percent, is up 5.4 percent for the year.

A five-year high in the University of Michigan consumer confidence report issued Friday along with the drop in the unemployment rate has Detrick, the Schaeffer's analyst, talking up consumer discretionary stocks. He is especially optimistic about "service companies" such as restaurants, retailers and home improvement stores, which are where consumers tend to spend their extra cash.

The $3.3 billion Consumer Discretionary Select Sector SPDR Fund is one ETF option. The fund, which costs 18 cents per $100 invested and yields 1.4 percent, has more than six percent of its assets in companies such as Amazon.com Inc, Walt Disney Co and Home Depot Inc. It is up 18.5 percent in 2012.

EARNINGS MOMENTUM

Not all surprises are positive, of course. Pankaj Patel, a quantitative analyst at Credit Suisse, focuses on companies that are the most likely to meet - as well as miss - estimates based on factors such as earnings momentum and recent guidance from executives.

Patel's list of likely earnings disappointments includes packaging manufacturer Sealed Air Corp and mining equipment maker Joy Global Inc. The shares of both companies have fallen this year due in part to concerns about slowing economic growth in China.

Among Patel's picks for positive surprises are publisher McGraw-Hill Companies Inc, biotech Amgen Inc and conglomerate Leggett & Platt Inc, which makes products ranging from steel wire to bedding. McGraw-Hill, for instance, grew its earnings per share by more than 25 percent in both the first and second quarter of this year. It is scheduled to report its most recent results on October 31.

The technology sector has a history of outperforming analyst expectations. Companies such as Apple Inc often beat estimates. But this quarter may be different, said David Abate, a senior wealth adviser with Strategic Wealth Partners in Seven Hills, Ohio.

As more consumers opt for tablet computers instead of traditional PCs or laptops, he's skeptical that firms such as Intel Corp will be able to meet analyst expectations. In a move that surprised analysts, Intel cut its third quarter revenue estimate by eight percent on September 7. The company's shares are down 10.6 percent for the year.

"There's diminishing demand in the PC market and we are concerned about (the company's) top-line growth," Abate said.

Analysts expect Intel to post earnings of 49 cents per share, a 23.7 percent drop from the same period last year. Investors will know if the music stops on October 16, the day Intel is scheduled to release its latest results.

(Editing by Lauren Young and Andre Grenon)