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Traders pin hopes for rally on company plans for buybacks and capital spending

  • Earnings estimates for the first quarter were already strong, but blasted higher after the tax reform bill passed.
  • The dividend story is expected to remain strong, but traders are pinning their hopes for a rally on two issues: buybacks and capital spending.
  • Jim Paulsen from Leuthold Group has noted that when business spending increases, the stock market, and in particular, capital goods stocks, outperform.
Traders work the floor of the New York Stock Exchange.
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Traders work the floor of the New York Stock Exchange.

Earnings to the rescue. Traders are relieved that there is finally a chance to change the conversation from the chaos of trade wars to the calm of revenue and profit.

"Unless something goes badly awry, companies are really looking strong this year," Christine Short from Estimize told CNBC.

The numbers are phenomenal: Earnings estimates for the first quarter were already strong at the end of the third quarter — analysts were forecasting an increase of 10.6 percent for Q1 — as the U.S. and global economy continued to expand. But once the tax reform bill passed at the end of December, analysts' earnings expectations blasted higher.

S&P 500: Q1 earnings estimates

Oct. 1: up 10.6 percent

Jan. 1: up 12.2 percent

Monday: up 18.4 percent

Source: Thomson Reuters

Earnings for the entire S&P 500 almost doubled in six months. This is pretty rare. Earnings estimates tend to go down, not up, as the quarter progresses, and certainly not almost double.

And they went up in the sectors that matter the most, which is to say technology (25 percent of the S&P) and financials (15 percent), the two biggest sectors. Estimated earnings more than doubled for financials in a six-month period, and almost doubled for technology.

Estimated sector 1Q gains

Technology: up 23.4 percent

Financials: up 24.4 percent

Source: Thomson Reuters

Traders will be listening to hear what corporations will be doing with their new-found money from the tax cuts. Early signs are encouraging. Bank of America looked at the announced spending plans of 150 companies about a month ago, and found a mix of one-time bonuses, expanding buybacks and dividends and more capital spending.

Tax reform: Who's doing what

(150 companies announce spending plans)

One-time bonuses: 30 percent

Retirement contribution: 20 percent

Expand buybacks/dividends 20 percent

More capex spending: 40 percent

Source: Bank of America

The dividend story is expected to remain strong, but traders are pinning their hopes for a rally on two issues:

1. They are expecting a surge in buyback announcements. There were roughly $500 billion in announced buybacks for 2017. Early estimates are that this could go toward $800 billion in 2018, an increase of greater than 50 percent.

2. They are looking for more capital spending. It's particularly encouraging that 40 percent of companies that made comments on their spending plans mentioned increased capital expenditures. Jim Paulsen from Leuthold Group has noted that when business spending increases, the stock market, and in particular, capital goods stocks (technology, materials, industrials and energy), outperform.

"At least since 1950, the relative performance of capital goods stocks (those most sensitive to business spending) have done best when business spending is leading the economy, and have often underperformed when the economy was driven primarily by consumer spending," Paulson said in a note to clients on Monday.

Of course, this could all be upended by trade war headlines, another topic expected to be addressed by CEOs. J.P. Morgan's Jamie Dimon has already been vocal about tariffs; I expect him to pontificate more on this topic during the bank's earnings call on Friday.

President Donald Trump is expected to meet with Mexican President Enrique Pena and Canadian Prime Minister Justin Trudeau at the Summit of the Americas in Peru at the end of this week. It's still not clear if any new NAFTA trade deal will come out of the negotiations, but any progress on trade reform will be welcomed by markets as a sign that deals can be achieved.