Sector Detector: Will Earnings Season Provide The Next Catalyst For Stocks?

More unnerving conflicts around the globe have flared up, but as usual, U.S. equity investors have given it nary a yawn as they seem to have become pretty much numb to the steady stream of unwelcome news, particularly out of the Middle East. Now we enter the summer version of earnings season. Although sell-side expectations have been reduced from the previous lofty forecasts coming out of the dismal Q1 numbers, we’ll see if earnings reports can catalyze a renewed bullish march higher, or a long-feared bearish correction, or perhaps a resumption of the sideways-to-upward summer consolidation that we have seen so far.

Going into Q2 earnings season, projections are for the strongest in several years due to resurgent GDP growth, the highest level of stock buybacks since 2007, and a weak U.S. dollar (while helps multinationals and commodity-oriented companies. Last week, Alcoa (AA) kicked off things with a strong report, which bodes well for the Industrial sector. This week, some of the biggest Technology sector companies will report, including Intel (INTC), Yahoo (YHOO), eBay (EBAY), and Google (GOOGL).

The other week, a patriotic pre-Independence Day holiday push took the Dow Jones Industrials Index above 17,000, the Wilshire 5000 Total Market Index above 21,000, and the S&P 500 to slightly above the upper trend line of its long-standing bullish ascending channel that has been in place for nearly three years. However, as I predicted last week, stocks lost their momentum in the post-holiday summer trading, and I still think there may be more downside in store before summer is over.

The Federal Reserve has signaled that October is likely to mark the end of their quant easing program, and eventually they will need to begin raising short-term rates and shrinking their balance sheet of those bonds they’ve accumulated. Nevertheless, the 10-year Treasury bond continues to remain strong with a low yield of 2.54%, which is back down to where it was a couple of weeks ago before a brief inflation scare nudged it up a smidge last week. Persistently low yields continue to push investors into equities in their search for both yield and total return. As unemployment drops, there eventually will be wage inflation pressures, which is a first step toward long-anticipated price inflation. So, it seems to many observers that there is greater risk in holding bonds at their current levels than stocks.

The CBOE Market Volatility Index (VIX), a.k.a. fear gauge, is still quite low, even after the minor pullback, closing last Friday at 12.08. Obviously, with such low volatility, short-selling clearly has not been working, and indeed after rising for a time, short interest is now at its lowest level since just before the financial crisis -- about 2% of float in S&P 500 companies. In fact, short covering was a likely driver of the pre-holiday push to new highs, but now that bullish fuel has nearly dried up. These signs of investor complacency are troubling to many market commentators and investment officers.

I still expect the market to pullback during the summer to test some support levels before heading to new highs this fall. However, we will need to see some top-line revenue growth soon, since P/E multiples are running out of room to grow without interest rates going even lower. In fact, ConvergEx has offered up a contrarian potential scenario in which weak consumer spending and hiring lead to a shallow recession here in the U.S. early next year, perhaps in addition to a worsening geopolitical crisis, that sends investors running for cover. Just one cautionary alternative to consider.

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The author has no positions in stocks or ETFs mentioned. The materials available from us are published solely for informational purposes. They are not to be construed as advice or ...

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