Stocks ended the holiday-shortened 4th of July week with a bang, which carried over to this week. But the real fireworks are still to come as investors digest second-quarter sales and profit reports in the weeks ahead.
The early results will help provide the direction for stocks, now that concerns over the Federal Reserve’s stimulus program are largely out of the way. But the questionable quality of the stock market’s recent advance doesn’t bode well for the bulls.
Since reaching an intraday low of 1,560 on June 24, the S&P 500 has moved above 1,650 again. This has the bulls breathing easier since it looks as if the brief stock-market correction may have run its course with a relatively mild drop of 7.5 percent.
|Lower-quality stocks have been leading the market higher.|
Ah, but looks can be deceiving, and this could just be the calm before the summer storm. After all, the bears can point to plenty of trouble spots that could easily derail the rally.
The European Union’s financial crisis, for example, is heating up again this summer with renewed political unrest and a growth outlook revised lower. Don’t look now, but bond spreads for the deepest-in-debt PIIGS nations (Portugal, Italy, Ireland, Greece, and Spain) are widening again.
Meanwhile, rising U.S. interest rates, the recent credit crunch in China, and upcoming earnings season are plenty to keep investors anxious. But it’s the character of the uptrend in stocks that concerns me most.
Low-Quality Rally Looks Suspect
Although market breadth has been decent overall, the rally so far this year — especially over the past few months — has been a decidedly low-quality affair.
According to Standard & Poor’s, dividend-paying stocks in the S&P 500 Index are up 15.1 percent this year, lagging non-dividend paying stocks’ 20.3 total return. During the market down-draft in June, S&P dividend payers provided no yield “support.”
And there are plenty more examples of lower-quality stocks leading the way:
* Take a look at performance by market capitalization: The large-cap S&P 500 Index gained 12.6 percent in the first half of 2013, while the S&P Mid-Cap Index was up 13.8 percent, and even more speculative stocks in the S&P Small-Cap Index jumped 15.5 percent.
Not much leadership from the blue-chips.
* Or, slice the data by S&P’s quality ranking, which rewards established, financially stronger stocks with a higher letter-grade rank. This year, A+ rated stocks rose 11.9 percent, while C- and D-ranked shares surged nearly twice as much at 19.9 percent.
Meanwhile, more speculative stocks that don’t even merit an S&P ranking jumped 20.3 percent.
* Finally, consider that the 100 most heavily shorted stocks in the S&P 500 Index — the shares investors see as most vulnerable to decline — are actually outperforming the index this year by more than 3 percentage points.
In other words, there have been plenty of “dogs” leading the stock market pack so far this year, while high-quality stocks seem to be shunted aside.
Such poor-quality market leadership means the level of speculation is rising sharply as this year’s rally has rolled on. To me, this is a bright flashing caution signal for stocks. And that’s why upcoming second-quarter earnings reporting season may hold the key to either extend the rally, or lead to a deeper correction ahead for stocks.
As has been the case in recent quarters, not much is expected from S&P 500 companies in terms of sales and profit growth when second-quarter results are posted. That can be either good or bad depending on the actual numbers and all-important management outlook.
First, estimated earnings growth for the S&P 500 is just 0.7 percent for the quarter, according to FactSet. This estimate has been steadily falling since the second quarter began in April; back then the estimate was 4.2 percent profit growth. But over the past three months, 107 companies have issued negative earnings per share guidance.
Compared to little positive guidance, it is the worst earnings revision ratio in 12 years.
The largest downward revisions to profit estimates have come from the materials, technology, and industrial sectors … all stocks that are highly sensitive to the economy.
On the bright side, one of the two sectors with upward profit revisions has been financials, perhaps because higher interest rates are expected to fatten profit margins for banks.
Sales gains remain just as hard to come by for S&P 500 companies. Revenue growth is expected to be just 1 percent for the second quarter; that’s down from estimated growth of 2.7 percent on March 31.
But the blessing in disguise here is that expectations are set so low for the S&P 500 this reporting season. Therefore, it shouldn’t be difficult for most companies to clear so small a hurdle with more positive than negative profit surprises in the weeks ahead.
If, as usual, most companies beat estimates by a few percentage points, we should witness decent results overall with most stocks under-promising and over-delivering. But any large-scale disappointments, or worse, downward guidance for second-half results would likely add to market anxiety.
The majority of reports don’t start rolling in until next week, with the peak of earnings season not until the final week of July. Still, early results from one Dow Jones Industrial Average bellwether is encouraging.
Materials firm Alcoa (AA) traditionally kicks off earnings season as the first Dow component to report results each quarter. Monday, after the close, Alcoa reported increased quarterly profit of $149 million, or 13 cents per share, a few pennies ahead of estimates. And according to FactSet, Alcoa is something of a canary in the coal mine for the market.
Over the past 10 years, Alcoa has beaten earnings estimates 48 percent of the time. But when its results exceed expectations, as they just did, it’s a good omen for stock-market performance.
In fact, whenever Alcoa’s profits beat estimates, the S&P 500 Index has moved higher 79 percent of the time, with an average gain of 3.6 percent over the next three months.
So perhaps Alcoa’s results are a good sign for the struggling materials sector … and for the stock market.