July 19, 2010
Last week we discussed that the “tidal waves of recent economic data suggesting weaker growth will ultimately engulf any attempt of a sustained bull run in the stock market” fueled by strong earnings. After announcements by Alcoa and Intel followed by three straight days of finishing at 1095-1096 level, which is around the falling 50-day moving average and a significant technical resistance point, the S&P tumbled 2.9 percent after a weak Consumer Confidence report on Friday. What is interesting is the fact that earnings season so far has been better than average according to the Wall Street Journal article “No legs for earnings rally.”
On paper, companies haven’t disappointed. According to Thomson Reuters, of the 48 S&P 500 companies that have reported through the end of last week, 75% have beaten estimates, compared with the historical average of 62%. Some 13% missed estimates, fewer than the typical average of 20%. Thomson Reuters adds that, on the whole, companies are beating estimates by 16% this quarter, compared with an average of 2% since 1994.
Earnings growth for the quarter is on track for just over 28%, according to Thomson Reuters, a figure that blends estimates with results from companies that have reported. That was enough to enable the rally to—briefly—grow legs, and pick up the spirits of many individual investors. A weekly sentiment poll by the American Association of Individual Investors on Thursday showed a near doubling in the percentage of its members who are bullish on the stock market, to 39.4% from 20.9% the week before. The last time optimism surged by this much was in early March 2009, when the stock market launched its yearlong bull run.
While positive earnings growth is usually a good sign, it doesn’t always reveal the full story in terms of the overall direction of the markets. When the economy is quietly humming along and volatility is low and stays that way, earnings surprises and individual stock selection normally play a significant role in an optimal investment strategy. During these times, value added can be achieved through the focus of idiosyncratic risks or what many pros call a “bottom-up approach”. Conversely, when uncertainty is in the air and the economy is on the verge of shifting gears as is the case today, performance is heavily influenced by economic data and macro themes in a “top-down approach.”
It seems simple of course but the real trick is determining the timing of the shift between the two regimes and which approach should be followed. That’s why it should not be a surprise that some analysts who are wed to a specific style of forecasting such as a bottom up approach, may continue to say that the recent sell off is nothing more than a “correction” as opposed to being a part of a much larger downward change.
Given the lackluster recent economic data which contrasts from indicators from earlier this year, it is apparent that the economy is in the process of shifting gears toward a slower economy. How far the decent goes is still undecided and on the table for now (ECRI is the lone exception since it is on the verge of signaling more than just a slowdown it seems). Due to this dynamic, upbeat earnings should give way to the growing macro headwinds in determining the direction of the overall markets.
Posted by Rom on 