April 12, 2010 - Market Milestones and Earnings Expectations
On the cusp of the first quarter earnings season, the markets are hovering around two milestones: Dow 11,000 and 4% on the 10-year Treasury.
The 11,000 level on the Dow, touched briefly on Friday, is psychologically important. The 11,000 level was flirted with in 1999 and 2000, but unlike 10,000 which has been criss-crossed over-and-over again dozens of times, 11,000 has only definitively been crossed to the upside once, in 2006. The move to 11,000 is a clear sign of a well-advanced recovery in the market. In a similar way, the March employment report, released on April 2, reflecting substantial job growth for the first time in the recovery was psychologically important to those that felt none of this recovery counts until the economy started creating jobs. The stock market rally becomes more meaningful for some once the Dow gets back to 11,000, where it was before Lehman Brothers failed — the event that precipitated the peak of the financial crisis and recession.
However, rather than a sign of more gains to come in the short term, we believe the stock market is due for another 5-10% pullback as the earnings season gets underway. It took the market two months to go from 10,000 to 11,000. Following a pullback to near 10,000 once again, we expect a rally to the highs with the Dow back over 11,000 by mid-year.
Similar to Dow 11,000, the 4% yield on the 10-year Treasury note — touched briefly last Monday, has not been seen since before the financial crisis. The yield rose to 4% briefly in mid-2008, but not since 2007 has the yield been definitely above 4%. This is partly a sign of recovery — higher yields reflect a
stronger pace of real economic growth. It is also a sign of negative things to come as accompanying higher mortgage rates threaten to stall the fl edging housing market recovery and make financing the budget deficit more costly. Rates may temporarily pull back toward 3.5% during the second quarter as
market participants take profits in stocks and commodities asset classes and buy bonds. However, we expect rates will continue to follow a volatile, but upwardly — sloping path this year.
We have previously cited why we believe the second quarter presents a number of challenges to the rally that we believe will result in another 5 – 10% pullback, including:
- the tendency of investors to sell during the earnings season,
- leading indicators are peaking, the Federal Reserve (Fed) may signal coming rate hikes,
- China may take more action to curb growth,
- European credit conditions may continue to deteriorate,
- the uncertainty surrounding actions on financial reform legislation may intensify.
“Buy the rumor, sell the news” is an adage often used to describe stock market behavior. This adage describes the market performance around the past several earnings seasons, when companies reported their financial results for the quarter. It is worth noting that the last three 5 – 10% stock market pullbacks took place leading into or during each of the last three earnings reporting seasons:
- Leading into the second quarter 2009 earnings reporting season, from June 12 – July 10, the S&P 500 pulled back about 7.1%.
- During the third quarter 2009 earnings reporting season, from Oct 19 to Oct 30, the index fell 5.6%.
- During the fourth quarter 2009 earnings reporting season, from Jan 19 through Feb 8, the S&P 500 was down about 8.1%.
Market participants have high expectations for first quarter earnings of S&P 500 companies illustrated by the stock market rally in the weeks leading up to the start of earnings season this week. One of the reasons investors expect strong results is that during the past few weeks the ratio of the number of companies that pre-announced lower guidance on their earnings for the quarter compared to those that raised their forecast was 1.2 (72 negative to 60 positive), well below the historical average pre-announcement ratio of 2.1. However, a below-average ratio has often raised the bar on expectations too high heading into the earnings season as the expectation becomes priced in for companies to beat analysts’ estimates by a wide margin. Over the past 10 years, a ratio of 1.2 corresponds with a decline of about 6% in the S&P 500 during the earnings season.
We believe investors’ expectations may be too high for the earnings season, but that does not mean the results will be weak. On the contrary, earnings per share for S&P 500 companies are likely to be up 36% over the first quarter of 2009 when the global economy was in the midst of a deep recession (about 15% on a rolling four quarter sum basis). Revenues are likely to be up 10% over the year-ago period. The biggest gains are in the Materials sector given the powerful rebound in asset class commodity prices over the past year as the global economy returned to growth.
The rising momentum in analysts’ earnings expectations has stalled with little change in expectations during the first quarter. The analysts’ consensus estimate hovered tightly around $17 per share for S&P 500 companies. Estimates for the rest of 2010 have also remained relatively fl at. We will be
watching to see if the momentum returns as results are reported, if not, the stalling in the upward momentum to earnings revisions is another near term negative for stocks.
Earnings growth is increasingly important as a driver of stock market performance now that a year has passed since the bear market low. We have reached the point around which earnings growth typically begins to outpace stock market price performance as valuations, or price-to-earnings ratios, peak after rebounding from a bear market low. Without the lift from valuations, stock price performance becomes dependent upon earnings growth for support.
We expect earnings growth to slow over the remaining quarters of 2010; however, growth is likely to remain in the double-digits each quarter this year. We adhere to our expectation, presented our 2010 Outlook published late last year, for about 25% earnings per share growth in 2010, while noting that the risk to our estimate may be to the upside. Key drivers of profits in 2010 include: the benefits of aggressive cost cutting, low interest and tax expenses, strong export growth, robust demand from businesses, and a solid pace of consumer demand. The solid support of earnings supports our
view for a modest pullback followed by a rally, rather than a more severe or sustained decline.
IMPORTANT DISCLOSURES: The opinions voiced in this material are for general information only and are not intended to provide specifi c advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your fi nancial advisor prior to investing. All performance reference is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.
Investing in international and emerging markets may entail additional risks such as currency fluctuation and political instability. Investing in small-cap stocks includes specific risks such as greater volatility and potentially less liquidity.
Stock investing involves risk including loss of principal Past performance is not a guarantee of future results.
Small-cap stocks may be subject to higher degree of risk than more established companies’ securities. The illiquidity of the small-cap market may adversely affect the value of these investments.
Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rate rise and are subject to availability and change in price.
High yield/junk bonds are not investment grade securities, involve substantial risks and generally should be part of the diversified portfolio of sophisticated investors.
© LPL Financial
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