This study examined emotion perception processes in preschool aged children presenting with clinically significant emotional and behavior problems, with emphasis on sadness perception accuracy (i.e., the ability to correctly identify sadness from expressive and situational cues) and anger perception bias (i.e., the tendency to perceive anger in the "absence" of concordant cues) as related to children's externalizing symptoms. Participants were 82 children (3-5 years of age) admitted to a psychiatric day treatment program. Children participated in a structured puppet play activity to assess emotion understanding. Mothers reported on children's externalizing symptoms and program staff reported on children's emotion regulation and negative emotional lability. Young children in this clinical sample demonstrated generally age-appropriate ability to identify basic emotions as expressed within prototypical social situations. Most emotion perception errors involved the over-identification of sadness. Children's decreased accuracy in sadness perception was associated with increased externalizing symptoms. Children's negative emotional lability contributed unique variance to the prediction of externalizing symptoms, with more labile children also demonstrating increased symptoms. Results underscore the role of emotion processes in early childhood mental health problems, with implications for emotion-based treatments of early externalizing behavior symptoms.