Before every earnings season, I look at a chart to see if there are any consistent price patterns that would allow me to draw conclusions about where prices are heading.
The chart below shows all 2011 earnings seasons, each being kicked off with Alcoa’s earnings announcement. Unfortunately, no crystal clear price patterns jump out. Although earnings numbers were initially well-received, they eventually led to a significant selloff.
In January, the S&P rallied for 28 days following Alcoa’s announcement, then sold off 6.9%. In April, the lag time between Alcoa’s earnings release and an 8.2% decline shrunk to 14 days. In July, the S&P dropped a whopping 20% just nine trading days after earnings season began.
Of course, thanks to a weak dollar, QE2 and corporations’ metamorphosis into lean, mean, profit machines (at the expense of millions of employees), earnings generally were good for much of 2011. In fact, Standard and Poor’s projected 2011 earnings to exceed 2007 peak earnings.
That’s a big elephant in a small room. Considering everything that’s happening, how could 2011 corporate earnings possibly be higher than in 2007? This question brings up the all-important issue of (over?) valuation. Let’s take a look at the prospects of a year-end rally before looking at the long-term implications of the valuations picture.
SeasonalityVia the ETF Profit Strategy Newsletter’s Oct. 2 forecast for the month ahead, I stated that “Even though October has hosted some ugly bear markets, it has also killed its fair share of bear markets. I don’t think October will kill this bear market, but it should spur a powerful counter trend rally.”
The same update precisely�outlined how this rally should come about: “The ideal market bottom would see the S&P dip below 1,088 intraday followed by a strong recovery and a close above 1,088.”
The S&P has bounced off support at 1,088 strongly and, with the seasonally strong pre-election year and with October, November and December ahead of us, stocks are likely to grind higher.
A Slow and Painful RallyThere’s good reason to believe this rally is going to be slow and painfully choppy. Seasonality supports higher prices, as does sentiment. Most investors and investment advisors still are bearish. The market usually delivers its downside installments after investors turn bullish again. It will take some time and higher prices to get investors to bite once more.
In terms of time proportions, we should remember that it took the S&P half a year to fall from 1,370 to 1,075. Even though much of the declines were quick and occurred within a number of days, the total time from high to low was over six months. A counter-trend rally that retraces a portion of those losses is likely to last more than just a few days.
However, since its bottom at 1,075, the S&P has rallied more than 150 points in a very short period of time. This rally has taken the S&P rather close to my upside target for this rally. The upside from current prices is somewhat limited.
With seasonality and sentiment pointing toward higher prices — the upside target keeping a lid on the advance — the logical conclusion points towards a drawn-out, grinding rally with many ups and downs and no huge net gain.
Long-term Valuation Picture
As mentioned at the onset of this article, Standard and Poor’s projected 2011 earnings to exceed 2007 peak earnings. The December 2010 ETF Profit Strategy Newsletter used Standard and Poor’s projections to create the following chart:
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A picture says more than a thousand words, and this simple chart certainly illustrates the irony of record earnings. This year’s earnings were supposed to soar to record levels with GDP stuck in a downtrend and unemployment persistently high.
The conclusion given in the December ETF Profit Strategy Newsletter was simple and sobering: “Buying at current prices with the expectation of long-term gains is almost certain to deliver despair and tears.”
Of course, rich valuations didn’t prevent stocks from rallying in late 2010/early 2011, but the rally was on borrowed time. The April 3 ETF Profit Strategy update outlined S&P 1,369 to 1,382 as the most likely range to host a market top of historic proportions.
Great Earnings and Poor PerformanceEarnings results leading up to the May market top at S&P 1,371 mostly exceeded expectations. Here are some earnings headlines:
AP: “Intel leaps past expectations, shares surge” — April 19, 2011
AP: “IBM earnings up 10%, helped by weaker dollar” — April 19, 2011
Bloomberg: “Record streak for S&P 500 earnings may rest with momentum kings Apple, GE” — April 21, 2011
Wall Street Journal: “World revs up U.S. profits” — April 21, 2011
AP: “GE CEO Immelt says global economy is improving” — April 27, 2011
AP: “Microsoft earnings surge 31%” — April 28, 2011
AP: “Sales growth the big surprise on Wall Street” — May 1, 2011
The only thing bigger than the surprise over sales growth was stocks’ reaction to the good news. Despite great earnings growth from the tech sector, the Technology Select Sector SPDR (AMEX:XLK) was unable to record new recovery highs. The Dow, S&P and Nasdaq all topped on May 2.
The Moral of the Earnings StoryEarnings are an important ingredient to the valuation formula. However, basing any investment decision on projected earnings is dangerous because corporate profits are closely tied to the stock market.
You can play the chicken or the egg here, but it seems to me that the stock market dictates earnings more than the other way around. If earnings were to drive stock prices, 2011 should have been a stellar year. Instead, the 2007 and 2011 record earnings projections led to major selloffs both times.
I find it beneficial to tune out the earnings noise and focus on the market’s price action and internal signals. This includes looking at charts, identifying important support resistance levels (such as resistance at 1,369 and support at 1,088) and looking at sentiment, seasonality, past chart patterns and trend lines/channels.
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The ETF Profit Strategy Newsletter analyses sentiment measures, technical indicators, support/resistance levels, historic chart patterns, seasonality and combines them with a healthy dose of common sense to come up with complex but easy to understand short-, mid- and long-term market forecasts.�
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