Market Insider

Earnings will tell if it's correction time for stocks

Early January trading has been choppy and rough, and still unclear is whether 2016 is ringing in a correction or just more whiplash.

The answer to that could come in the next several weeks, when earnings season gets underway and investors weigh the corporate profit outlook against a market that many view as fully priced at 16 times future earnings. The market has been uneasy that weaker manufacturing activity in the U.S. could dampen corporate earnings in a bigger way.

Traders work on the floor of the New York Stock Exchange.
Brendan McDermid | Reuters

Stocks closed mixed Tuesday, after a big downdraft Monday. The rose 4 to 2,016, and the Dow climbed 9 to 17,158, but the Nasdaq fell 11 to 4,891.

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On the immediate horizon Wednesday is a look at the minutes from the Fed's last meeting, where it raised interest rates for the first time in nine years. The central bank's vice chairman, Stanley Fischer, also appears on CNBC's "Squawk Box" at 8:30 a.m. ET. Traders will be watching for clues on when the Fed might next raise rates.

Jobs-related data could be a factor that gives the market a sense of direction, since employment and inflation are key to the Fed's internal discussions on interest rates. The market is currently pricing in just a couple of hikes while the central bank is forecasting four for 2016.

ADP payroll data is expected at 8:15 a.m. ET Wednesday, and it is viewed as the warmup act for Friday's government jobs report, the most important release of the week. There is also international trade at 8:30 a.m. and factory orders at 10 a.m. Services PMI and ISM nonmanufacturing data are also reported.

"What we've seen over the last couple of days is investor indecision," said Julian Emanuel, equity and derivatives strategist at UBS. "You typically see when the new year starts the losers outperform, and the winners lag."

He said there's been no economic confirmation that the underperforming energy, materials or industrial sectors are going to improve. "We think the Friday jobs report could actually be a catalyst for that if the payrolls are good."

Emanuel said for this reason, earnings season will be even more important than normal.

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"The market is correcting by correcting in time, while it waits for confirmation that earnings can start growing again. From our point of view the most important thing when we think about the next couple of months is how stocks are going to react to earnings," Emanuel said.

"We have not thought (as much) about this in maybe two years, and now we know where the Fed is. We know what they're intending to do, but we also know that by the same token, like the Chinese government, they do what do whatever is necessary if things start to get dicey."

Manufacturing weakness in China and fears about the pending end of selling bans and other restrictions put in place last summer roiled Chinese stocks and global markets Monday. Chinese officials have been taking steps to calm markets since then, and Shanghai stocks closed nearly flat on Tuesday after a 7 percent decline Monday.

In the U.S., the manufacturing sector is in recession though it is a much smaller part of the economy. The latest ISM manufacturing report Monday showed a larger-than-expected contraction and was the weakest since 2009.

"If you look at manufacturing ISM ticking down again, you could make the case that at some point this quarter, you're going to start seeing recession warning signals. We don't think that's the case but in this kind of environment where the volatility is much higher, even though the range is much tighter, it tells you the range of potential outcomes is very, very wide," said Emanuel.

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He said the bar has been lowered for fourth-quarter profits, and it's likely actual earnings reports will easily beat expectations for a decline of 3.9 percent in S&P profits.

"It's like everything else. It's going to be beaten. If you look at the last several quarters, the energy, the materials really haven't been as sensitive to earnings because they're the ones you know are going to be bad, and that company is not going to give meaningful guidance. The question is how do the stocks that have led the market do in earnings," Emanuel said.

There are strategists who believe the selling this week and last is the start of a bigger downward move.

Ari Wald, Oppenheimer Asset Management technical analyst, has been calling for a first-quarter pullback, and he says this is it. The market has been showing all the classic signs, such as narrowing leadership.

"We're looking at 1,900 for the S&P 500," said Wald. "Our work looking back at history and the duration of this (last summer) correction would suggest to us we needed a little more time. That was a concern. Participation under the surface was a concern. Fewer stocks were in an uptrend and volume trends would suggest the correction hadn't really run its course. There's been heavier volume on shares that have been declining rather than rising."

The S&P 500 hit its all-time high of 2,134 in May, and it never returned to that level. "We're saying yes we are expecting a correction. We are not, however, expecting a steep decline," he said.

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Emanuel says the S&P has been trapped in a 12 percent range going back to 2014, but he believes the market can break out of it. "Our view is new highs are certainly likely in the first half of 2016," he said. Emanuel expects stocks to be helped by the anticipated earnings recovery, a slow path for Fed rate hikes and a burst of merger activity, ahead of new leadership in Washington next year.

Wald said he believes the market is in a secular bull market even though some parts of the market have been hit hard.

Traders have been watching the decline in the Dow transports, down 18 percent last year, since they are viewed by some as a sign of economic health. "I think it's an area that drags on the market ... it's more of a play on economic activity," said Wald.

But he also says that while the transports are behaving poorly, they are doing just as they did in past secular bull markets — peaking in the "middle innings" in both the 1953 and 1989 bull runs. "So it's a near-term warning, but not out of line with what we saw in other secular bull markets, when you look at how they performed over the past," Wald said.

Emanuel said the market could sell off more but he does not expect a pullback of any significance now.

"When you think about it from the big picture, when people are crabby and not doing anything and are in general underexposed and arguably somewhat over-hedged, markets do not top. ... Markets top when things are good and people are optimistic," said Emanuel. "That's part of the reason — aside from what we expect to be a rebound in earnings — why we think this range is going to be resolved higher. I think you could chop around here. Maybe 1,950 in the S&P is a level but it doesn't feel like it's going to be a material, really material pullback."

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