Stocks face earnings test amid 'breakout in optimism'

Stocks could easily break out to new highs in the week ahead, as earnings become the next test for the market.

The S&P 500 ended the week at 2129.90, less than a point below its record high. Stocks surged Friday on the better-than-expected June employment report, after a rocky week, where uncertainties about the U.K. vote to split from the European Union continued to upset markets.

"Earnings could tell a big story," said Peter Boockvar, market analyst with The Lindsey Group. "I'm not exactly clear on what it's trading on right now. I'm not exactly clear with the fundamental story. … Everyone's just chasing price here."

Pedestrians walk along Wall Street near the New York Stock Exchange (NYSE) in New York.
Michael Nagle | Bloomberg | Getty Images
Pedestrians walk along Wall Street near the New York Stock Exchange (NYSE) in New York.

With Brexit fears simmering and the June jobs report clearing away some labor market concerns, the market may actually respond to the first incoming reports of the second-quarter earnings period in the week ahead. If this quarter is like others, most companies will beat estimates. Alcoa is the first report out on Monday, and JPMorgan Chase, Citigroup, Wells Fargo and BlackRock follow later in the week.

"I think we're going to go higher over the next few months. I think we're going to go to 2,200. We're going to have a breakout in optimism," said James Paulsen, chief investment strategist at Wells Capital Management. Paulsen said the more-than-year-long earnings recession should soon be coming to an end and economic data should keep picking up.

While stocks rallied, so did bonds. Bonds at the long end of the Treasury curve — the 10-year and 30-year — continued to pull in buyers, as the yields of other global sovereigns plumb deeper into negative territory. Bond yields continued to fall Friday even though the June employment report of 287,000 nonfarm payrolls removed some of the anxiety created by May's weak report, revised even lower to just 11,000 jobs created.

"I think economic momentum is returning," Paulsen said, adding the Citigroup index of economic surprises has been signaling improvement.

Strategists say the stock market is in a sweet spot, while the Fed appears set to stay on hold for the time being, and the economy appears to be in better shape than it was several months ago. While not positive for financial companies, the historically low interest rates could drive investors into stocks.

Paulsen said the rally could continue for a while, and the broad-based nature of it is encouraging. For instance, small caps outperformed Friday, driving the Russell 2000 up 2.4 percent on the day. For the week, the Russell was up 1.8 percent, just under the 1.9 percent gain of the Nasdaq. The Dow closed 1.1 percent higher on the week, at 18,146, about a percent from its all-time high.

Many strategists expect the market to remain volatile, and some, like Goldman Sachs, see a correction on the horizon. Bank of America Merrill Lynch strategists also expect the S&P to trade lower, reaching 2000 by year end.

Bonds could ultimately become a worry for stocks, said Paulsen, describing the fact both markets are moving higher as a "conundrum." Prices move opposite to bond yields, and yields at the long end have been falling as investors see U.S. debt as more attractive to negative yielding German bunds or Japanese government bonds. "We're going to run smack dab into how ridiculously priced the bond market is," Paulsen said.

Macro concerns could continue to overhang the market in the coming week, as more than a dozen Fed speeches are on the calendar as well as Friday's important retail sales for June, industrial production and CPI inflation data. China also has inflation reports Sunday, trade Wednesday and GDP and retail sales Friday.

"The next thing is going to be earnings. I think the earnings will ultimately drive the direction of stock prices here as always. A lot of this Fed-watching, Brexit-watching induces short-term volatility in the market, but what ultimately is going to drive stocks up or down is earnings, and as we get the second-quarter earnings report, that will determine where we go next," said Michael Arone, chief investment strategist at State Street Global Advisors. "Earnings are expected to be poor, and it's the fifth consecutive quarter of earnings per share declines. I think that is priced in."

Earnings are expected to fall by 4.8 percent, after a 5-percent decline last quarter, according to Thomson Reuters. The third quarter is also expected to be slightly negative. Energy companies are forecast to turn in the worst results again, with a roughly 75-percent decline expected for the sector. Financials, which kick off the early part of the earnings season, are expected to see earnings fall by about 5.5 percent.

"I think what's interesting is how companies are forecasting the rest of the year — if they're signaling slowdowns or concerns, I think the market will continue to be in this directionless mode. If they're a little more optimistic about the second half, that will be interesting," Arone said.

Traders especially are watching for company comments on the impact of the expected U.K. split from the European Union. But even before the Brexit vote late in the final days of the last quarter, earnings were expected to be weak.

Bank of America Merrill Lynch strategists Friday trimmed their earnings expectations for this year and next, by 3 and 2 percent respectively. "We forecast S&P 500 earnings growth to trend from 7 percent in 2015 to 0 percent in 2016 and 4 percent in 2017," the analysts wrote. They noted that at 2,098, the S&P 500 was trading at 17.9 times their cumulative 2016 earnings-per-share estimate of $117 for the index, while their year-end price target of 2,000 implies a 16 times multiple on their 2017 EPS estimate of $125.

The bond market will also be a highlight when the Treasury $56 billion in auctions in the week ahead. The Treasury scheduled $24 billion of three-year notes Monday, $20 billion in 10-year notes Tuesday, and $12 billion in 30-year bonds Wednesday. Both 10-year and 30-year yields were at record closing lows Friday. The 30-year was yielding 2.10 percent, while the 10-year was at 1.36 percent.

Cantor Fitzgerald rate strategist Justin Lederer said he expects the auctions to go well, given the big interest in bonds. "I think [three-year notes] will find some buyers given the way Treasurys are a buy, but I think some may shy away now that we're back in the camp of talking about a 2016 rate hike," he said. Fed funds futures Friday were indicating the market sees a 24-percent chance of a rate hike by December, up from 12 percent before the jobs report.

"I think 10s and bonds will go well. The talk of the town right now is the need for yield," Lederer said. He added that the Fed speakers are less important, with the Fed likely on hold until the end of the year, but the jobs report did rekindle talk that the Fed could raise rates in 2016 if it sees several more months of solid jobs gains.

"Fed speeches are going to be important but have a lot less weight than they did two or three months ago when we were talking about a June rate hike. The [jobs] number was good today, which definitely helps, but obviously July is not in the cards. I don't see that happening in September because of the election and the uncertainty. I think December is a strong possibility," Lederer said.

Robert Sinche, global strategist at Amherst Pierpont, said Chinese economic figures should not be a factor unless there is a big miss in the data. He said the traders continue to watch Europe, now that the Brexit vote has created an atmosphere of uncertainty. "I think the focus is going to shift away from Brexit and shift to the European banks' stress tests at the end of the month," he said. European banks stocks have been under pressure and are one area upsetting the market, as traders fear they have balance sheet issues and will have a hard time generating income in an environment of negative yields.

As for the U.S. economic data, "retail sales is the biggie, but earlier in the week you've got small business optimism and Jolts," he said. The job openings data is carefully followed by the Fed.

"If you get another record high number of job openings, in May that would suggest this is a supply constraint, not a demand constraint," said Sinche. He said he is also watching to see if the optimism in the NFIB survey picks up, since it has started to improve in April and May. "We've seen in ISM that June was a robust month. If you get a confirmation from the small business index, it would suggest things are a lot broader."

What to Watch


Earnings: Alcoa

10 a.m. Kansas City Fed President Esther George on economy


Earnings: Fastenal, Adtran

6 a.m. NFIB survey

9:15 a.m. Fed Gov. Daniel Tarullo on shadow banking

9:35 a.m. St. Louis Fed President James Bullard

10 a.m. Wholesale trade; Jolts

1 p.m. Three-year note auction

6:30 p.m. Minneapolis Fed President Neel Kashkari

9:30 p.m. Cleveland Fed President Loretta Mester on financial stability


Earnings: CSX, Yum Brands

8:30 a.m. Import prices

9 a.m. Dallas Fed President Rob Kaplan on economy

1 p.m. 10-year note auction

2 p.m. Federal budget; Beige book

6 p.m. Philadelphia Fed President Patrick Harker on economy

10:30 p.m. Cleveland Fed's Mester on economy


Earnings: JPMorgan Chase, BlackRock, Delta Air Lines, Taiwan Semiconductor, Progressive, First Republic Bank

8:30 a.m. Initial claims; PPI

10 a.m. St. Louis Fed President James Bullard

11:15 a.m. Atlanta Fed President Dennis Lockhart

1 p.m. 30-year bond auction

1:15 p.m. Kansas City Fed's George on economy

7 p.m. Dallas Fed President Rob Kaplan on economy and policy


Earnings: Citigroup, Wells Fargo, US Bancorp, PNC, Shaw Communications

8:30 a.m. Retail sales, CPI, Empire State survey

9:15 a.m. Industrial production

10 a.m. Consumer sentiment; Business inventories

1:15 p.m. Minneapolis Fed's Kashkari and St. Louis Fed's Bullard in discussion