Good Evening: The major U.S. stock market averages rose for a sixth straight day today, and the S&P 500 set a new closing high for 2009 in the process. I will first breeze through today’s events before examining what I think could be a fascinating earnings season. Since there are important similarities and differences between this quarter and last, I’ll try to look at the U.S. markets from different angles in search of predictive clues. Fundamentals, technicals, sentiment, and Fed policy all go into the mix, but it will just as important to watch how various stocks REACT to their earnings reports. Whether investors feel forced to “chase performance” into year end, or “lock in performance” by taking profits will likely be the swing variable. Taken as a whole, these reactions will set the tone for how the averages perform during the balance of 2009.
During the past two weeks, stocks corrected a bit when the economic data turned squishy and because the Fed threatened to some day cap the gusher of liquidity still flooding the markets. Reaching their nadir on the very day of the nonfarm payrolls release, stocks have since come roaring back. Today’s Columbus Day rally was simply a light volume extension of last week’s upturn. There was no news of significance, including a report by our Department of Homeland Security that Al Queda is still alive and has sympathizers living in our midst. This non news flash coincided with some gentle profit taking this afternoon, but most of the indexes clung to gains by day’s end. The final tally saw the Russell 2000 trail with a fractional loss, while the Dow Transports were today’s best performer after tacking on 0.8% . The bond market was closed, the dollar continued to weaken, and commodities continued to levitate. Led by a 2% gain in crude oil and very firm grain prices, the CRB index rose 1.7% today.
Back in early July I noted that the averages went into Q2 earnings season fresh off a correction of nearly 10%. Expectations weren’t very high, the earnings bar companies had to jump over was set pretty low, and many portfolio managers were less than fully invested. While I cannot claim to have predicted the resulting rally during the entirety of the Q2 reporting period this summer, I did note the “set up” could easily lead to an updraft in equity prices. I also noted that if disappointments were to occur, then the stage would also be set for a retest of the March lows. The one outcome I felt safe in predicting in July, however, was that prices would NOT go sideways. Now that Q3 earnings will start arriving in a rush starting tomorrow, we have another interesting set up, one that is at the same time both similar and different from what we saw back in July.
The similarities include a quantitatively easy Fed, generally rising risk appetites and an unemployment-data-induced correction just prior to the onslaught of earnings reports. The differences, though, are more glaring. As we head into tomorrow’s announcements by JNJ, INTC, and CSX, the S&P stands at 1076, a full 23% higher than the closes in the 870s when Alcoa kicked off the Q2 season back in July. Back then, the economy was weaker, earnings expectations were lower, the technical underpinnings of the market were starting to weaken, and investor sentiment was anything but trusting. Let’s examine how these variables now look in October before trying to draw any conclusions.
Fundamentals/Economic Backdrop: Compared to the negative GDP reported in Q2, the economy in Q3 looks almost vibrant. “Cash-for-clunkers” and other stimulus programs gave the U.S. economy a boost this quarter, as did a modest uptick in demand and some inventory adjustments. There are many (including Messrs. Roubini, Rosenberg, Soros, and Gross — see below) who view the economy’s response to all the stimuli pouring out of Washington as temporary — and prone to reversal as soon as Q4. I have a lot of sympathy toward these views, but the upcoming earnings reports are for Q3. Temporary or not, GDP growth might have been 3% or more for the quarter just ended, and we should also keep in mind that various leading economic indicators are still flashing bright green. Then again, all of these tailwinds are well known, if not priced in to equities at this level, so it’s hard to say this variable is of much help in divining the future. We simply do not know if the “new normal” is yet ready to assert itself as the consensus outcome. Valuation is also a bit of problem, but though many would call them fundamental indicators, I’ll save elevated P/E and P/B ratios for the next section.
Technical Indicators: The “tape”, which is simply the catch-all title for various technical indicators, has been very firm in the run up to the earnings season that will soon be under way. There have been many more up days than down days, breadth has been positive, and corrections have been very brief. Looking at the averages themselves, the highs and lows have been sequentially higher, and the momentum crowd has rarely been happier. The biggest negatives are volume and valuation. The former has been disappointingly weak and is hard to square with a new bull market in equities, while the latter looks increasingly stretched. One must completely ignore P/Es based on trailing twelve month earnings, and even “core earnings” (which conveniently ignore write-downs) must be rationalized to fit S&P 1076. It’s only when “normalized earnings” (i.e. pre-recession) are conjured up that current valuations make any sense at all. Another less than stellar reading, depending on just how “book value” is measured, has most P/B ratios in the stratosphere after all the post-bubble write-offs. And, if equities pull back from here, it will be hard to dismiss the potential for a double top in the S&P (the intraday high in September was 1080; today’s high was 1079). The net-net is that while the tape is pretty firm, expectations are high and a sell off from a potential double top cannot be ruled out.
Sentiment: As you will see in the table below, AAII investor sentiment is currently mixed. Other measures I’ve seen during the past 10 days are likewise close to neutral. The journey to this mid point between optimism and pessimism has been a wild one this year. Pessimism dominated during most of the first half, while optimism has had the upper hand since May. This conflict is quite apparent in some of the risk appetite measures tracked by Credit Suisse. Jim Cramer can claim all he wants that institutional investors are afraid of their investing shadows, but CS says risk appetites for U.S. equities and U.S. credit have risen from panic to euphoria in well less than a year. Like sentiment among individual investors, measures of institutional sentiment have pulled back somewhat since the S&P hit 1080 on an intraday basis in late September. The VIX could be considered a technical indicator, but it’s really one of the best sentiment indicators around. Down from 80 last year, the VIX has notably declined. But the VIX has not yet printed below 20, which usually marks the upper end of the complacency zone. As an indicator therefore, sentiment is neither bullish nor bearish right now.
Investor Survey Results (an AAII exclusive)
Results as of October 1, 2009
This week’s survey results saw bullish sentiment rise to 43.55%, above its long-term average of 38.9%. Neutral sentiment rose to 20.97%, below the long-term average of 31.0%. And bearish sentiment fell to 35.48%, above the long-term average of 30.1%.
Fiscal and Monetary Policy: The Fed has been easing since August of 2007, and monetary policy can only be described as exceptionally easy. The Fed ruminates once in a while about having to remove all the monetary stimulus they’ve unleashed into the banking system, but it is highly unlikely the FOMC will vote for a rate increase any time soon. The ECB, the G-20, and Chairman Bernanke himself have all chatted up the need to be responsible “at some point”, but Mr. Market looks to be from Missouri on this claim. How else can one explain the continued weakness in the dollar in the face of policy threats and the supposed embracement of “a strong dollar” by top officials? For its part, Congress may have tried to give away the store with the 2009 stimulus package, but 2010 is an election year. Does anyone think Congress will sit on its hands as unemployment closes in on 10%? Furthermore, does anyone really believe that the Fed will tighten during next year’s (re)election campaigns? Market participants want to believe that Congress and the Fed will act responsibly, but it’s hard to see our government officials (whether elected or appointed) taking any action which might threaten economic growth.
So, if — other than an easy Fed — the indicators I’ve cited point up, down, and sideways at the same time, then what should an investor try use as a guide during the upcoming earnings season? The fundamentals are OK for now, but they could weaken. The technicals are firm, but not universally so, and sentiment measures are not conclusive at current levels. Valuations matter, but only over time. They are a notoriously poor tool for market timing. If you are content to just stay invested as long as the Fed continues to hold rates near zero, then be my guest. It’s worked before. But since we might not know just when the Fed will tighten, or when the economy might weaken, we need to watch for signs that investors have had their fill of equities. Perhaps Q3 earnings will give us the clues we need.
Since there have been very few negative pre-announcements, I have little doubt that earnings in Q3 will meet or beat consensus estimates. What’s important is not whether these reports “beat the street”, but how “the street will greet” the expected good news. In the months after the March lows, stocks rallied on all news — good, bad, or indifferent. But lately, some companies haven’t roared ahead after reporting decent numbers. Alcoa’s steady decline after a surprisingly good Q3 may or may not be representative of what’s to come, but it would be important if it became a trend. It’s easy to explain away a stock that drops after missing its numbers, but it’s tougher for market participants to swallow a lower stock price after the company in question logs stellar results. Whether it is due to simple profit taking or something more sinister in the outlook for the company, stocks that fall after releasing good news do not often make ideal purchase candidates. If it happens to enough companies during earnings season, then a correction or worse might be in the offing.
Then again, if most stocks rise after positive earnings announcements, then the rally might still have legs. The S&P 500 could even rise to 1121, which is the halfway mark (in technical parlance, a 50% retracement) between the 2007 high of 1576 and the 2009 low of 666. Paying attention to the overall reaction to earnings rather than to the earnings themselves may just yield some important directional clues these next few weeks. We’ll soon see if an almost 60% rally off the March lows is indeed too much too fast, or whether there’s still a dance left in the old girl yet. In fact, some will claim that this entire commentary is just a long-winded way of saying, “don’t fight the tape”. I don’t mind a bit, just so long as folks don’t confuse the above with “momentum investing”. I honestly think the upcoming earnings season will reward thoughtful investors. Whether portfolio managers are in the mood to chase profits or lock them in, how they respond in the weeks ahead will be important. If we can pay attention to market reactions on a micro level, they just might reveal some macro level insights.
— Jack McHugh
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