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Earnings Woke Up the Market, but Can It Continue?

Published: Friday, 17 Jul 2009 | 8:18 PM ET

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By: Patti Domm
Executive Editor

Earnings season has put some luster back in the stock market, but it may have a tougher time scoring gains in the week ahead.

Nearly 30 percent of the S&P 500 and 40 percent of the Dow 30 report. That includes such major companies as Caterpillar, McDonald's, Microsoft, Coca-Cola, Morgan Stanley, Merck, Boeing and Apple. Markets will also be watching testimony from Fed Chairman Ben Bernanke on the economy and Fed policy before Congressional committees Tuesday and Wednesday.

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Despite some steep profit and revenue declines, investors latched onto every bit of heartening news they could find in the past week's earnings reports, pushing major indices up about 7 percent. Major banks, technology and drug companies, as well as economic bellwether General Electric [GE Loading... () ], reported profits above forecast, but typically on big drops in revenues and not without serious cost cutting.

"I would be happy with not giving much of it back next week," said Art Hogan of Jefferies, of the market's gains. "We're not going to see anything great in earnings. It's just a question of whether they're going to be better than expected, and that's the best we can hope for."

The Dow raced ahead by 597 points, or 7.3 percent to 8743, while the S&P 500 jumped 61, or 7 percent to 940, and the tech-driven Nasdaq soared 7.4 percent to 1886.

The bond market in the past week saw selling, and the dollar weakened against the euro, losing a percent to $1.4099. The dollar gained 2 percent against the yen. Many commodities were higher on the week, with gold gaining 2.7 percent to $937.20 per troy ounce and oil jumping 6 percent to $63.56 per barrel.

This earnings season is particularly important because of corporate America's ability to give a fresh view of the economy, in comments about the outlook, orders, spending, inventories and costs. For the most part, traders are looking to the tech sector to deliver the best news on future earnings.

"The key question the market is looking to find the answer to is when and if there's a turning point for earnings," said Deutsche Bank U.S. equities strategist Binky Chadha. "That's not going to happen this quarter or next quarter. The macro economic forecast is for a long slow recovery. I think it's likely more in the fourth quarter."

When earnings turn, year-over-year comparisons will look positive. The deep drop off in the last year's fourth quarter profits, and improving profit picture has many looking at this year's fourth quarter as a time when there will be a difference in the complexion of earnings.

"There comes a point where top line stops falling, and they've cut costs too much, and in a sense margins start to improve. You're going to see a big pickup in margins," he said.

Chadha said there is also a high level of uncertainty about earnings in certain sectors that has to change before the market can really move higher. He said that shows up in the high levels of "dispersion" in analysts' estimates for financials, materials, energy and consumer discretionary stocks. In other sectors, the dispersion is close to historical averages. Dispersion is calculated by looking at the standard deviation of analyst estimates, he said.

For financials, for instance, the dispersion is usually about three to four percent, but it is currently at 37 percent, showing a lot of disagreement among analysts on financial company earnings. That was apparent in the big beats by Goldman Sachs [GS Loading... () ], JPMorgan Chase [JPM Loading... () ] and Bank of America [BAC Loading... () ] this past week. Currently, earnings surprises have been positive for an average 71 percent of the 55 S&P 500 that have reported so far.

"Sequential earnings (quarter-to-quarter) are going up but they are going up very modestly. That implies modest upside for equities until later in the year. Then things could change," Chadha said. He said he is neutral equities and has a target of 1,060 on the S&P this year.

Bonds: 'We Have Not Seen All of the Sellof"

Treasurys were under pressure in the past week, and that trend could persist in the coming week, says Ajay Rajadhyaksha, head of U.S. fixed income and securitized products research at Barclays Capital. He said some data improvements, including housing starts and jobless claims, as well as better bank earnings worked against bonds. The yield on the 10-year was at 3.645 percent late Friday, compared to the 3.29 percent yield of a week earlier.

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"We have not seen all of the selloff," said Rajadhyaksha. However, "bank earnings so far have been positive. Next week, the regionals start to report, and they do not have the benefit of investment banks to offset profits ... As investors look at regional bank earnings, and if they see things are still pretty bad in a large part of the banking sector, you might see some support for Treasurys."

Another important discussion for the bond market in the week ahead will play out on Capital Hill when Fed Chairman Ben Bernanke gives his semi-annual update to a House Committee Tuesday and Senate Committee Wednesday. A big emphasis could be on the Fed's "exit strategy," or the unraveling of the programs it has undertaken to bail out the economy and financial markets. "It depends on what he says about a time line," he said.

Tony Crescenzi, market strategist and portfolio manager at Pimco, said Bernanke may give more information on the direction of the balance sheet, which is expected to expand more before it starts to shrink. He too said there could be more detail on the timing, of great interest to markets.

"He could lay out what the Fed could do. There are well known ways to exit—to raise the interest rate on reserves, to sell securities, to raise the Federal funds rate, to absorb balances by the Treasury Department. Treasury could sell T-bills and deposit money at the Fed," said Crescenzi.

Bernanke may also explain why the Fed believes growth will pick up so much in 2011, to a projected level of 3.8 percent to 4.6 percent. "What gives them the confidence in that? Does he expect to be stimulating it til then?"

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Crescenzi said Bernanke will shy away from political statements during the testimony, and it's not likely his reappointment will be broached in the hearings. This is Bernanke's final testimony before his term expires in January. "The thinking is markets will know by September whether he's been reappointed. September or October. I can't see how in he midst of all this they have a changing of the guard. It's still a fragile situation. He's got built-up credibility," he said.

Econorama

Besides Bernanke in the week ahead, markets are watching a few economic reports, including leading indicators Monday; FHFA home price data Wednesday; weekly jobless claims and existing home sales Thursday, and consumer sentiment Friday.

Crescenzi said he is watching the inventory element of the housing data. "The inventory story is really important ...we want to see if inventories continue on the downtrend because in both new home sales and existing home sales, we've seen supply numbers move downward, especially for new homes, which are at a decade low," he said. In May, the inventory level was 3.798 million, down from a peak of 4.57 million in July, 2008. Crescenzi said a normal level would be 2.5 million.

"As supply starts to shrink, the bidding dynamic would start to improve," and prices would improve, he said.

Crescenzi said he is also watching the jobless claims, which have been affected by the shutdown and, now, restarting of auto production. Jobless claims showed an improvement in the past week, to 522,000 for the week of July 1. "Most of it's a distortion but there's something going on there potentially," he said, adding it would take several weeks of numbers.

CONTINUED: Technical Misfire; Earnings Lineup

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