Weighing the Week Ahead: Earnings Season

Once again, it is time to focus on corporate earnings reports.  For more than a year there has been a chorus of skepticism about earnings.  Here are some typical assertions:

• Earnings cannot be sustained in a period of slow economic growth.
• Strong earnings gains are impossible without the consumer.
• Earnings growth through cost-cutting cannot be maintained.
• And variations on these themes….

It is important to recognize that these predictions have all been proven wrong — repeatedly, for more than a year.  The stock market performance has dramatically lagged the strong earnings growth, resulting in ever-lower P/E multiples on both and forward earnings.

Meanwhile, there is continuing economic growth, an increase in consumer spending, and an increase in revenue.  This is all happening despite continuing high unemployment.

Evaluating earnings season should be done against this backdrop.  Before doing so, let us do a review of last week’s events.

Background on “Weighing the Week Ahead”

There are many good services that do a complete list of every event for the upcoming week, so that is not my mission.  Instead, I try to single out what will be most important in the coming week.  If I am correct, my theme for the week is what we will be watching on TV and reading in the mainstream media.  It is a focus on what I think is important for my trading and client portfolios.

 

Last Week’s Data

The most important new data for last week was the employment report.  Our forecast was for a loss of 110,000 jobs, one of the most accurate public predictions.

The Good

• Market action.  The market has adopted a “Don’t fight the Fed” mode, where participants think that economic weakness will be the target of aggressive action.

•  The ECRI indicators improved yet again.  In April I explained about misleading interpretations of the ECRI index.  In June, I updated the analysis.  There are several sources who, despite not knowing the makeup of the ECRI index, use it to forecast a recession.  One of them even sees a 100% chance.  Another has the most widely-cited fancy graphs in the investment blogosphere — without ever citing what the ECRI says about interpreting their own data.  For the record, the official ECRI interpretation is still in limbo — slowing growth (aka ‘soft landing’) versus another recession.  Here is a nice video discussing the ECRI readings in the context of the jobs report.  If you really want to understand what is going on, take five minutes and watch it.

• Mr. Buffett’s favorite indicator shows gains.

• Rail traffic remains strong.

• The DJIA had a Golden Cross, the 50-day moving average crossing the 200-day.  We will probably also soon see a Golden Cross in the S&P 500.  My summer interns are back in college, but someone should do the research.  How many of those sources that trumpeted warnings about the Death Cross, the Head-and-Shoulders, and the Hindenburg Omen are now writing about the Golden Cross, the Upside Down head-and-shoulders, and the failure of the Omen?

The Bad

The bad news this week is all about employment.  Many observers of the perma-bull persuasion tried to emphasize the growth in private payrolls in the most recent employment report.  They were joined by bearish brethren who celebrated the loss of government jobs.

Both viewpoints are incorrect.  Government services are an important part of the US economy.  We all use and consume the work of teachers, firefighters, police, military, social security administrators, government health professionals, and many others.

It is both facile and deceptive to dismiss government jobs as worthless.  Whether viewed in terms of services provided or employing workers, a job is a job.  Even though the loss of nearly 100K jobs reflected government cutbacks, the loss is very real.  Extended unemployment also worsened.

We are very far from what is needed — a growth of nearly 150K jobs per month to absorb new entrants to the market, and much higher to reduce unemployment.  This was a poor jobs report.

Unnoticed by most was the preliminary estimate of benchmark revisions.  The BLS checks its monthly report against actual data from state reports and does an annual benchmarking process.  This is an honest and effective way to check the actual estimates.  The estimated revisions suggest that employment gains have been over-estimated by about 30K per month.  This brings the reports closer to our own monthly forecasts.  It is not good news, but the change is much lower than the 1 million plus adjustment we saw last year.  (I expect to review this more carefully.)

 

The Confusing:  Bogus Opinions about Quantitative Easing

I have a simple proposal that would save everyone a lot of time.  Before anyone is allowed to pontificate about the merits of quantitative easing, the pundit would have to demonstrate a minimal level of knowledge.  Let us try the following:

In three sentences, please explain what quantitative easing is, how it is implemented, and what it is intended to accomplish.  (n.b., slogans like “printing money” do not constitute an acceptable answer.)

This would probably eliminate nearly everyone, and confront CNBC with a major problem.  How would they do any interviews if they could not ask people questions about things where they had no knowledge?

Meanwhile, the market continues to trade on expectations for Fed action, a policy which hardly anyone understands.

The Week Ahead

This week is about earnings.  I am not very interested in the inflation data.  It will be unimportant unless there is a major upward spike.  Some will see a decline in the core rate as evidence for more quantitative easing.  Some will also look to the Fed minutes, but again I expect very little.  I am always interested in the weekly jobless claims, but we have several weeks before the next employment report.

The most important news will be about earnings.  This earnings season starts with the market at the high end of the recent trading range and the P/E ratio very low.

If “good news is good news” the market can break out to much higher levels.  I expect every report to be tested in several ways:

• Results versus the expectations, including the whisper number;
• Whether revenue met expectations;
• Changes in future guidance:
• Comments on the economic environment.

The difficulty in meeting all of these tests, in the face of intense skepticism, helps to explain the P/E multiples.  The first reports will give a hint about the market reaction.

A Good Question

Most people are skeptical of earnings estimates, arguing that they are too optimistic.  Despite this, companies beat estimates by a ratio of better than 2-1.  What is the explanation?

The first reports will give a hint about whether the market will compress P/E multiples even further.  If not, the market could move much higher on strong reports.

Our Own Forecast

As we have been for most of the recent rally, we remain bullish.  With few sectors in the penalty box, there are more attractive ETF choices in addition to many low P/E stocks with good yields.  We continue our multi-week bullish posture in the weekly Ticker Sense Blogger Sentiment Poll.   Here is what we see:

•  87% of our 55 ETF’s have a positive rating, up from 95% two weeks ago.
• Only 9% of our 55 sectors are in our “penalty box,” down dramatically from 80% last week.  This means that there are many attractive sector and stock opportunities.
• Our universe has a median strength of +25, down slightly from +32 two weeks ago.

For trading accounts, we had full exposure during the past week.

[For more on the penalty box see this article.  For more on the system ratings, you can write to etf at newarc dot com for our free report package or to be added to the (free) weekly email list.  You can also write personally to me with questions or comments, and I’ll do my best to answer.]

Conclusion

The market has continued to improve in tone.  I am going to repeat the conclusion from two weeks ago.

The market moved closer to a viewpoint we have espoused for the last several weeks.  It had several voices, including this one:

“The concept of a double-dip recession has been replaced with slow and steady improvement, and even if we don’t get it, we have a Federal Reserve that’s ready to step in and support the rally,” said Art Hogan, chief market analyst at Jefferies.

The futures got a big pop Friday morning after a similar statement from David Tepper.  For me, this was hardly fresh news, but it is nice to see people joining in.

I continue to see a bullish environment for both traders and investors, and our accounts reflect this.