An old saw when it comes to investing is “buy the rumor, sell the news”. Over the last month and a half we have seen just the opposite as market participants sold on the rumor of a tough second quarter earnings season and then, last week, bought on the news that it turned out to be less bad than expected.

After fears of bad news on earnings helped to push stocks down 7% from June 12 to July 8, stocks rebounded 7% last week as the S&P 500 posted the biggest weekly advance since the beginning of the rally back in March. The fuel came mainly in the form of better than expected news on earnings as companies such as Goldman Sachs Group Inc., Intel Corp., and Johnson & Johnson beat analysts’ estimates. Financial stocks soared, even as lender CIT Group appeared to be headed toward bankruptcy after failing to secure a federal guarantee for its bonds.

While earnings are still down sharply from the second quarter of last year, results have proved better than feared and the outlook for coming quarters has improved, with growth expected to return by year-end. Of the 38 S&P 500 companies that reported second-quarter results since July 8, 30 beat analyst consensus estimates. Since July 8, the consensus for second quarter earnings per share has moved up by about 50 cents, or about 4%. The range of expectations between the highest and lowest estimates for each company in the S&P 500 for the second quarter has narrowed as confidence has improved. Third quarter estimates have also risen slightly as companies offer upbeat guidance.

Now that investors have recalibrated their expectations for earnings, it may be harder for the stock market to advance, even if companies continue to exceed expectations. Also, it is possible that we may have heard the best of the news. Historically, the companies that tend to report early in the season have not been very representative of the rest of the S&P 500 companies for several reasons, including:

1. Companies that report early tend to be concentrated in a few sectors such as Information Technology—which has been one of the better performers.
2. Harder hit sectors like the retailers in the Consumer Discretionary sector tend to report toward the end of the season due to the fact that their fiscal quarters end one month later than the calendar quarter.
3. Within sectors, those companies that had a more favorable operating environment in the second quarter tend to report earlier in the season. For example, early reporters in the Financials sector such as Goldman Sachs benefitted from strong trading and underwriting businesses, which are not shared by the many regional banks still to report that continued to suffer from commercial real estate losses.

Almost 150 companies in the S&P 500 are scheduled to report results next week. It is unlikely results will be strong enough to continue last week’s momentum and break through the high end of the range for the stock market. A range of about 880 to 950 on the S&P 500 has prevailed since early May as the stock market consolidated the 40% gain from the low on March 9.
Economic data also boosted investor confidence last week:

1. Although distorted by the auto company bankruptcies, the number of Americans filing claims for unemployment benefits fell last week to the lowest level since January.
2. Retail sales rose more than economists estimated.
3. Industrial production and the New York regional factory gauge were better than expected, a sign that activity in manufacturing continues to improve.

Next week’s release of the index of U.S. leading indicators is likely to post a third consecutive monthly rise in June offering investors another sign the economy may be emerging from the recession. However, investors’ increasingly high expectations for the economic data raise the bar for upcoming reports and also raise the risk of disappointment.

A wild card for the market next week will be the semi-annual testimony of Fed chairman Ben Bernanke to Congress on Tuesday and Wednesday. We believe it is the post-crisis exit strategies that will dominate the testimony and questions—especially since small steps to scale back the support to financial system are already being taken. Due to the improvement in the credit markets, the Fed announced changes last month to the programs created to mitigate the crisis following the failure of Lehman Brothers on September 15. The Fed announced that it will let one program lapse in October, one in December, and four others in February. The Fed also announced it will scale back the size of two of the programs. The programs being scaled back have seen much less demand from banks in recent months.

The risk is that market participants hear that the Fed is focusing on the exit strategy and price in more rate hikes and other actions that withdraw government support for the credit markets. This outcome may reverse the recent cyclical, re-inflation theme that has helped to propel stock market leadership.