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Market Insider: Earnings Remain a Tailwind for Stocks

Published: Friday, 24 Jul 2009 | 8:31 PM ET

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By: Patti Domm
Executive Editor

Corporate earnings will serve as a tailwind for the stock market in the week ahead, but gains could be constrained after an 11 percent run over the last two weeks.

About 30 percent of the S&P 500 reports earnings, and there's key economic data, including GDP for the second quarter and durable goods for June. Earnings reports are expected from major oil companies, like ExxonMobil [XOM Loading... () ], BP [BP Loading... () ] and Chevron [CVX Loading... () ]; entertainment companies, like Disney [DIS Loading... () ] and Viacom [VIA Loading... () ]; Travelers [TRV Loading... () ], and dozens of others.

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Traders say they expect the market to consolidate its recent gains, but the trend remains higher for now." You're entitled to some rest. The tree doesn't grow straight to the sky," said Art Cashin, director of floor operations at UBS. Cashin said he personally expects to see a bit of a sell off in the coming week. He said the major items he is watching are the corporate reports and the Treasury's massive auctions of more than $200 billion in notes and bills.

Stocks have galloped higher on the back of better-than-expected earnings reports, even as many companies' revenues continued to shrink. The Dow was up 349 points at 9093, a near 4 percent gain. It's 11.8 percent move in two weeks is the best two weeks in more than nine years. The S&P 500 was up 4.1 percent at 979, and the Nasdaq, fueled by tech, rose 4.2 percent to 1965.

Traders have been skeptical of the rally, but as stocks have gained, the bull camp has converted even some of the more skeptical. At the same time, traders say there's not enough proof the economy's recovery will be strong enough to avoid a double dip down.

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That fear has made the earnings reporting period even more important, as investors try to measure the health of not only companies but the broader economy. So far, 77 percent of the S&P 500 companies reporting earnings have come in above forecast but profits are still down 31 percent from last year's levels.

Profit Picture

JPMorgan chief U.S. equities strategist Thomas Lee has been more optimistic than most on corporate earnings, and he says there actually is some good news in this quarter's reports. The more important message is that revenues are growing sequentially, or quarter over quarter. According to JPMorgan research, 72 percent of Russell 1000 companies, reporting so far, show sequential revenue growth from the first quarter to second quarter.

"You'll see the improvement there before it shows up year over year. For me that's really confirming," he said. The biggest revenue gains were in the financials, with revenues up 8 percent. Staples and technology revenues are up 6 percent.

Some analysts believe the sequential comparison is not an accurate measure because of seasonality, but Lee said the message is that the situation is stabilizing.

"The growth should be further in Q3 versus Q2. We though the story in Q2 was sequential topline would grow," he said, but he added that cost cutting has made profits grow more than expected. "We're just thinking if you get sequential revenues up again and you have this cost cutting in place then you have even stronger (results).. We're looking at this progressively, as a nice progression of revenues helping drive some nice progression of earnings growth."

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Citigroup economist Steven Wieting found some similar positives in a bleak earnings period. He raised his forecast for 2009 and 2010 S&P 500 EPS in the past week because of the strength of earnings reports this quarter. He now expects EPS of $51 to $56 for 2009, and $56 to $62 for 2010, still below others on the street.

"It's a surprise, given macro conditions were unfavorable for non-financial earnings, that the improvement has happened," he said. "The surprise is that the pickup in non-financial margins has occurred earlier than expected."

"...The truth be told [this] could have an impact on [companies'] willingness to restore production and employment," said Wieting.

"The earnings decline was less severe than expected," he said. "The commodity-related earnings have picked up more than expected," he said. Costs are under control, and there's greater flexibility for margins to hold up, he said.

"Just as the stock market rallies and financial conditions improve, all these things could be self-fulfilling...but we don't want to go overboard," he said.

Lee said earnings improvements could make stocks look cheaper and cheaper and that could help fuel the stock market.

"I think for the next six months, we'll definitely have higher prices...but the average bull market lasts three years, and I think it's still too early to say whether this is it," he said.

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"Multiples are attractive in stocks and earnings are rising. We do have global recovery, and we do have a lot of unused capital. There's a lot of cash on the sidelines, plus I think investors are pretty skeptical," he said.

Lee said the capital flows into equities funds only turned positive at the end of April. He said in 12 months of 2003 to 2004, $237 billion poured into stocks. In the past 12 months, $150 billion flowed out of stocks funds. "We've had $39 billion of in-flows since the end of April. That's twice the pace during the same number of weeks in 2003-2004," he said.

Traders say they are encouraged by the pickup in trading volume, and the fact the market is showing resilience. They are also reporting a more diverse trend of buying by investors who are branching out into less defensive sectors and small caps.

David Stec, trades options on exchange traded funds (ETFs) for Group One. "Pretty much across the board, what we're seeing is the fear premium in those back month options is coming in line with front month options," he said, indicating there's less fear in the market. He said the trend is apparent in options for ETFs on the S&P 500, the Nasdaq and Russell 2000.

The VIX, the Chicago Board of Options Exchange's volatility index, is viewed basically as a fear meter for the stock market.

"There's not a lot of activity," said Dan Deming, who trades the VIX for Stutland Equities. He said investors "expect the VIX to trade in this 22 to 25 area going out until October."

CONTINUED: Why Corporate Bonds Are Hot

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