Earnings & The Economy
We are well into Q1 earnings season; overall earnings are down about 35% but many firms are beating lowered targets. We are also starting to see forward guidance improve, a signal to some the worst may be behind us. So far it appears cost cutting has adequately cushioned revenue declines for many U.S. corporations.
Earnings Data as of Friday, May 5th:
- 65% of S&P 500 companies have reported
- Two-thirds have beaten low expectations vs. one-quarter that have fallen short
- S&P 500 firms collectively are beating targets by 10.4%
- S&P is expecting a 20% drop in earnings next quarter
- Healthcare was the only sector to report positive earnings growth
Data provided by Investors Business Daily.
The market likes the results. The S&P 500 bolted 9.7% during April on top of an 8.5% gain in March.
Cost cutting alone, however, may not be enough to sustain the improved environment. Eventually the year-over-year earnings comparisons will become harder to improve upon without revenue growth.
Evidence the economic contraction is slowing has added fuel to the rally. A weekly measure of future U.S. economic growth moved up to a 13-week high. The annualized growth rate also continues to improve prompting Lakshman Achuthan, Managing Director for ECRI, to declare "...an end to the U.S. recession is now in clear sight." He expects the U.S. economy to emerge from the recession later this summer.
A slowdown in the economic contraction along with a somewhat improved earnings environment has contributed to the rally in a wide range of asset classes. The real test for the S&P 500 will come when it reaches its January high of 934. The NASDAQ had no trouble passing this milestone back in early April.
Leading stocks are slowly starting to deliver as well. Last week the IBD 100 (fundamentally strong but younger and smaller companies) outperformed other indexes, a characteristic need for a sustained rally. Other post-contraction stock market up trends in '32, '38, '75, & 2002 also showed solid and tenacious leaders were slower to emerge.
I would suggest this is going to be a dicey week for stocks since the bank stress test results will be released. Then again, since some stress test information has already been "leaked" without inflicting much damage, Thursday's announcement may have little impact. It is no surprise many banks are expected to need additional capital. What will be interesting is how the banks are ranked, what the total capital shortfall amounts to, and how the troubled banks address their capital shortfalls. All this while the government is authoring a regulatory change that will allow it to take over, and if necessary close, financial firms that have become "to big to fail". All this may suggest the final chapter in the credit crisis recession is still being written.
Other challenges remain with company valuations and trading volume. Current valuations tend to fall in the fair or expensive range when compared to bear market bottoms in the last 100 years. Stocks don't have to hit the lowest bear market valuation levels before recovering, but given the systemic nature of the current recession, it is reasonable to expect valuations to fall toward the lower end of the range. For more detail on the subject see the following commentary by William Hester of Hussman Funds. Lower valuations are not a requirement for a sustained rally, but they would lower the risk of the current rally becoming a bear market rally.
Every recession and bear market has its own character. This will not be the first time trading volume arrived late to the party. Near term, few market observers would deny it will be important for trading volume to increase if we expect the current rally to continue.
Given the amount of government market intervention and the less dismal economic and earnings reports that have sparked this rally, stock prices may have gotten ahead of themselves over the last couple of months. Don't be surprised if this turns out to be a "sell in May and go away" month. Then again, if volume picks up and the market continues to advance, the odds increase that the lows of this bear market are behind us.
If you have tip-toed back into the market over the last few months you should be sitting on some nice gains. At this juncture I am inclined to wait for a pullback or consolidation before committing more funds. If you are afraid the market is going to get away from you, consider concentrating on those markets that have exceeded their January highs. I would suggest entering partial positions slowly, that way you can add to positions that are outperforming, look for new leaders, and take advantage of lower prices if a pullback develops.