Will earnings tell the story markets need to hear?

Published Sun, Jul 13 2014 6:21 PM EDTUpdated Mon, Jul 14 2014 6:25 AM EDT

Patti Domm

Investors will be turning to the dozens of earnings reports in the coming week to see whether Wall Street's high hopes for a second half rebound are possible.

There are also two days of congressional testimony from Fed Chair Janet Yellen Tuesday and Wednesday, a potential catalyst for more volatile trading.

Second-quarter earnings are seen growing at a fairly healthy 6 percent pace. But more importantly will be any clues that come from companies' commentaries, as to whether there really will be a bounce back in growth in the second half, and whether the consumer and corporate spending will be strong enough to help drive it.

Traders work the floor of the New York Stock Exchange before the closing bell in New York.

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Stocks have risen to record highs this year with a key assumption built in—stronger second half growth will help earnings grow by double digits. Those market gains have also been stoked by the idea that easy monetary policy will not abruptly reverse, so Yellen's semiannual economic testimony will also be very important.

"Monetary policy has meant a lot for stocks for several years, and will continue to mean a lot for stocks. I think earnings will help keep a floor under stock prices, but volatility will be driven by anything that happens in the bond market and anything that happens with monetary policy so Yellen will be front and center," said Gina Martin Adams, institutional equities strategist at Wells Fargo Securities.

Adams said the divergence between stocks and bonds has added some tension to markets: "We're all expecting a fairly good growth rebound in the second half of the year, but the bond market tends to be telling you a different story." The yield on the 10-year fell to 2.51 by Friday, and the two-year, trading earlier in the week at a three-year high, was at 0.46 percent late Friday.

In the past week, a fairly mundane release of Fed minutes injected volatility into markets when traders read it as reassurance the Fed will not move quickly to raise rates. In that release, the Fed also clarified that its quantitative easing program would come to an end in October, as expected by markets.

Bond yields, moving higher at the short end ahead of the meeting, reversed as investors bet the market was too aggressive in expecting an earlier rate hike. Economists had been pulling their expectations for Fedrate hikes forward because of the stronger-than-expected June jobs report. Many economists now see the first hike in the second or third quarter of next year.

Stocks were higher on the Fed release Wednesday but tumbled Thursday on global growth concerns and worries about a Portuguese banks. But that overreaction was no doubt the result of a market that has become too complacent, according to Steve Wieting, global chief strategist at Citi Private Bank.

"We've had pent up volatility…sleepy markets in terms of concern, very, very light hedging activity as evidenced by the low volatility levels," he said. "I think we were ripe to see a break in the surface of calm that we've had."

Wieting said it's not clear whether a correction is on the horizon, but said in the past 20 years the third quarter has been vulnerable to a correction 40 percent of the time, twice as often as the fourth quarter.

"I still think there's a pretty strong opportunity for a correction in the market, affiliated with the Fed policy shift. There's still a period of time before we have to face the music that we're heading for tighter policy," said Adams, adding better earnings growth could help the market as it struggles with the Fed later in the year. She expects gains in second half profits of 9 to 11 percent, but some analysts still forecast single digit growth.

"In the first quarter, we thought earnings estimates were clearly too low, and the second quarter was no problem. I still think the second quarter is not a problem but the second half has 11 percent estimated EPS growth. It's going to be harder to achieve," said Wieting.

The VIX, meanwhile, rose 22 percent in the past week to 12.59, still a relatively low level, but a sign that more market participants are hedging. The VIX is the CBOE's Volatility Index, a measure of market expectations of near term volatility based on stock index options prices.

The Dow in the past week declined 0.7 percent to 16,943, and the S&P 500 was off 0.9 percent at 1,967. The Nasdaq fell 1.6 percent, to 4,415. The worst performer, however, was the Russell 2000, off about 4 percent, to 1,159, in its worst weekly decline in two years.

"In the context that the Fed is on the verge of tightening policy, the riskiest area of the market is high multiple stocks," said Adams. A number of analysts have warned that the stocks in the small cap Russell 2000 are overvalued, at a forward price-to-earnings ratio of about 19. "If you're going to paint things with a broad brush, small cap multiple expansion was multiple the large caps. It was extraordinary, and small caps are at risk in an environment where multiples are not a driver of stocks. There's also domestic exposure and consumer."

Adams recently changed her view on sectors and says those where earnings are most at risk are consumer-related. "It's really difficult to make a case for anything consumer-related."

Expectations are way too high for spending, and consumers were hit by the slowdown and weather impact in the fourth and first quarters.

"It's not that the consumer is really falling apart. They'renot the accelerating part of the economy. They're not the accelerating part ofthe earnings stream into the S&P 500," she said. Just in the past week, a number of consumer related companies warned that the economy has impacted their customers—including Container Stores, Lumber Liquidators and Wal-Mart.

"In anticipation of rates increasing next year, investors have started to rotate out of these sectors," Adams said.

She recently upgraded materials, and energy and continues an overweight on technology, all sectors showing improvements in earnings.

"Parts of the index where earnings were dormant are coming alive. That's creating thistransition in sector performance," Adams said, adding tech is benefitting from apickup in capital spending. "We're seeing the tech numbers improving dramatically. Tech is of the only sector other than health care that has seen positive earnings revisions."

About 55 S&P 500 companies report in the week ahead, many of them financials like Goldman Sachs and J.P. Morgan and big tech names, like Google and Intel.

What to Watch

Monday

Earnings: Citigroup, J.B. Hunt

Tuesday

Earnings: Goldman Sachs, Johnson and Johnson, JP MorganChase, Intel, Yahoo, CSX, Pinnacle Financial, Commerce Bancshares

8:30 a.m.: Retail sales

8:30 a.m.: Import prices

8:30 a.m.: Empire State survey

10:00 a.m.: Business inventories

10:00 a.m.: Fed Chair Janet Yellen before Senate Banking for semiannual testimony on economy

Wednesday

Earnings: Bank of America, BlackRock, PNC Financial, Northern Trust, US Bancorp, Charles Schwab, Abbott Labs, Yum Brands, eBay, United Rentals, Textron, St. Jude Medical, Taiwan Semiconductor, First Republic Bank, SanDisk