Friday Look Ahead: Focus on Earnings Could Help Stocks

Shopping for any excuse to rally, stock traders found it in Thursday's chain stores' sales, and those reports may provide a clue to the earnings season.

NYSE trader
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NYSE trader

While the reports were by no means stellar, the fact that they did not contain many negatives was good enough.

Barclays Capital's Barry Knapp said of the 15 retailers he monitors, the average sales increase for June was 3.9 percent, exactly in line with expectations. There were only three that changed their earnings guidance.

"Given the magnitude of the decline, the risk is you get a real significant marking down of forward guidance. There's not that much evidence to think that would be the case," he said.

"To me, I'm wondering if what happened with the retailers' same store sales today was indicative of what we might see from the earnings season," said Knapp, who heads U.S. equities portfolio strategy. Traders have been concerned that while many companies may beat earnings estimates, companies could still sour the market with negative forecasts for the next quarter.

But If they don't make negative comments, "that could be enough to trigger a rally. At best you describe it as a relief rally, and maybe it lasts four weeks," said Knapp.

Stock strategist Andrew Burkly of Brown Brothers Harriman also sees the opportunity for a market rally on earnings. "The surprising thing going into the quarter is margins are forecast to go down, which we think is one of the surprises," said Burkly.

He notes that there's been a seasonal strengthening in second quarter margins going back to 1999. Analysts expect margins to average 7.7 percent, and Burkly expects an upside surprise of 20 to 30 basis points.

"We think industrials are going to have a good upside surprise. We think health care and tech are going to have a good upside surprises. Those are two where we think margins are forecast to contract the most," he said.

"Margins will compress at some point, as labor comes back, as input comes back. That's normal. We're just saying it's too soon for that to happen," he said. Earnings are expected to increase by 26 percent for the S&P 500, and Burkly expects companies to beat by a normal range of about three to five percent, compared to last quarter's extremely high 12 percent.

Burkly said the technical damage to the market makes it all the more important for any rally to have a strong foundation. "It puts us more on guard in terms of any kind of rally coming out of here. The fact the pull back did damage makes the impetus for a stronger rally even more important. If you get a weak rally, after technical damage, it's even more worrisome," he said.

"I think we're really at one of those difficult times...when the technicals are arguing against the fundamentals. The macros are difficult, We're not in the double dip camp, but we think there will just be slower growth," he said.

Burkly said he's watching the 1070 to 1075 level on the S and P. "It's a pretty important level on the resistance side. We'll be keeping an eye on it in the next couple of days. If we get above it, we'll get to 1100, but I'll be watching it as a potential fail zone," he said.

He is watching some industries this earnings period to see if they "kitchen sink" problems, while blaming external events. For instance, he believes concerns about the weaker euro hitting multinational profits is overdone, and those companies are candidates to make excuses. "We're going to be watching the oil drillers and see if they're throwing in charges in terms of lost contracts," he said.

On Thursday, a U.S. Appeals Court rejected the Obama Administration's request to keep a moratorium on deep water oil drilling in place, while the court decides on the legality of the ban.

Earnings season starts Monday with Alcoa's report. J.P. Morgan,Intel, Bank of America, General Electricand Googlealso report next week.

What To Watch

Friday's markets have little in the way of economic news, and certainly much of the focus will continue to be on the start of the earnings reporting season next week. Wholesale trade data is reported at 10 a.m. A decline in weekly jobless claims to 454,000 was also a positive for Thursday's market.

The Dowrallied into Thursday's close, giving it a 120 point gain and taking Dow out of correction territory. At 10,138, it is now 9.5 percent below its April high, and it is up 4.7 percent in the past three days. The S&P 500was up 9 at 1070, an important resistance zone. The materials sector, up 1.5 percent was the best performer, and tech, up just a half percent, was the laggard.

Treasury yields rose, as investors sold bonds ahead of next week's auction of 3-year and 10-year notes and 30-year bonds. The yield on the 10-year, as a result, rose above the key psychological level of 3 percent, to finish at 3.020 percent, its highest yield since June 28.

Brian Edmonds, Cantor Fitzgerald's head of interest rate trading, said yields could continue to rise into those auctions, but that the current trend to low yields is not over. "I think we're going to push to lower yields at some point. If the market gets back to (10-year yields of) 3.10, 3.20, that's the upper end of the range for the short term. If stocks hold up and the euro rallies, I think our market will be under pressure," he said.

Burkly said the move in yields could actually be a plus for stocks. "I think there's a general asset allocation switch that's going to happen relatively soon. If the earnings do come in a little better than we think, they (investors) start to trim back," on bonds, he said.

Capital Gains

One of the biggest worries on the horizon is what tax changes will be made in the next year, and most immediately when the Bush tax cuts expire.

Treasury Secretary Tim Geithner made a surprising comment on the matter Wednesday, when he told CNBC's Larry Kudlow that the Obama Administration supports a top rate on capital gains and dividends of 20 percent next year. That is above the current 15 percent level, but well below the market's worse fears -- a rate of 39.5 percent top rate.

"I thought that was a big deal," said Knapp, adding it would be bullish for the market if approved.

Knapp, in fact, expects concerns about taxes and fiscal tightening to start to impact the market not long after the earnings season, as the mid-term elections come into focus.

"When you're dealing with fiscal policy and you put politicians in it, you can't put a normal statistical distribution around it because anything could happen," he said.

Burkly shares some of the same concerns, and he points out that the street is more divided than ever on the direction of the market.

"We think the fundamentals win out and we think the recovery is more sustainable than people are thinking. It's also a slow drift higher. We still think we're going to challenge the highs by the end of the year, which is 1220 on the S and P. It may not happen until fourth quarter. It may be a choppy summer," he said.

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