When it comes to the health of the U.S. stock market over the next few weeks, corporate earnings will tell the story.
Alcoa Inc. (NYSE: AA) kicks off the third-quarter earnings season on Wednesday. My guess is that over the next few weeks, as third-quarter earnings are reported, we will have the opportunity to witness a powerful rally that will scamper the Standard & Poor’s 500 toward the 1,200 level and the Dow Jones Industrial Average to the 10,000 threshold. My expectation is that major tech and industrial companies will create upside earnings surprises and issue positive comments about a stabilizing global economy.
My only concern is that there have been very few negative earnings preannouncements so far. Although that sounds like a good thing, the record shows that quarters with the highest level of negative announcements tend to result in the best market performance. It's one of those weird market paradoxes, but usually it's good to get bad news out of the way so that investors can later bid prices up in their time-honored "better-than-expected" routine.
Two Ways to Ride the Bull
Stocks stabilized on Friday, recovering from early losses to move briefly into positive territory before sliding lower into the closing bell. A bad jobs report hung over the trading session like a dark thundercloud. As a result, the major indices posted their second consecutive weekly loss. But there are signs the storm is about to clear.
For the day, the Dow lost 0.2%, the S&P 500 lost 0.5%, the Nasdaq Composite Index lost 0.5%, and the Russell 2000 lost 0.6%.
It appears a few buyers were crawling back into the market to buy the dip, reinforcing our view that the bulls still reign and that weakness should be seen as an opportunity to extend long positions: Lowry Research Corp. notes that buying power increased slightly, while selling pressure decreased. Breadth improved from Thursday's heavily negative session, as declining issues outpaced advancers by a 2:1 ratio, while down volume accounted for 68% of total volume.
Industrial and consumer discretionary stocks led the decline, with the Industrials SPDR Exchange-Traded Fund (NSE: XLI) and the Consumer Discretionary SPDR ETF (NYSE: XLY) both falling 1.3%. Consumer staples continue to show relative strength, rising 0.3%. The sector has been a laggard coming out of the March low, rising 32% compared to the 52% rise in the S&P 500 and the 66% increase in consumer discretionary, or retail, stocks. Whether it's because of defensive positioning, or bearish investors finally deciding to join the bull market by focusing on value, these stocks look ready for continued gains.
A Crossroad For U.S. Stocks
Since the U.S. Federal Reserve announced on Sept. 23 that it would not be extending its direct purchases of mortgages and U.S. Treasuries, stocks have lost more than 4%. At the time, I wondered if the Fed would impede the bulls by beginning to exit some of its liquidity programs.
While that remains to be seen – in the near term, at least – is whether the stocks that look ripe for a rebound after sliding lower on a spate of softer economic news will actually regain that higher ground.
By all rights, with investors already shaky after Thursday's plunge, the bears should have smashed the major indices to smithereens on Friday. The fact that they didn't feel confident enough to press their advantage, along with some other corroborating evidence, indicates we may finally have a classic oversold scenario on our hands. This should help support stocks until Alcoa kicks off the third-quarter earnings season on Wednesday.
According to Paul Desmond and his team at Lowry Research, the percentage of stocks above their 10-day moving average has plummeted to just 8.13%. Not since the March low has this metric fallen to such depths. Not during the brief May sell-off. Not during the prolonged weakness in June and July. Not during the dramatic but short-lived drop in the beginning of September.
Such widespread weakness indicates sellers are not worried about earnings quality, valuation levels, or performing any other type of fundamental analysis on what they are throwing out of their portfolios. Good or bad, everything is getting dumped in an attempt to reduce risk exposures. Obviously, this is a sign pessimism has probably reached an extreme.
Tom McClellan of the McClellan Market Report likewise points to the Arms Index ($TRIN). Developed by Richard Arms, it compares the ratio of advancing to declining issues and compares it to the ratio of up volume to down volume. A low reading – say 0.5 – indicates an overbought condition, while a high reading of 2.0 or higher shows an oversold condition.
Thursday's session registered a big 3.63 on the Arms Index. This is the highest reading since early February. The good news is that – by this measure – stocks are at their most-oversold levels in seven months. The bad news is that the last time the Arms Index was so high, they went on to lost 22% before bottoming out in early March.
And I would also point out that the McClellan Oscillator, developed by Tom's father several decades ago to measure oversold conditions by gauging the balance between rising and falling stocks, is also more oversold now than it was at the early September and mid-July lows. And it is at about the same level as it was at its March lows.
These are not like light switches that turn on the buying. But they certainly make professional investors more likely to step in now if they have been waiting for a moment when they could purchase on a 4% to 7% dip.
And finally, stocks should soon start enjoying the benefits of a renewed surge in liquidity courtesy of the Federal Reserve. Although the Fed pulled the punch bowl away in one area, by announcing the discontinuation of its direct debt purchases, it has quietly been gunning the money supply. Obviously, something has Fed Chairman Ben S. Bernanke & Co. worried.
As you can see in the chart above, the effective Federal Funds Rate – which is the short-term, inter-bank lending rate that the Fed targets – has plummeted over the past few weeks. At 0.07%, it stands well below the Fed's target rate of 0.125% and beneath the levels that prevailed late last year in the wake of the credit crisis.
Effective interest rates now stand at their lowest level since 1961.
McClellan's research shows that stocks react to changes in the effective Fed Funds rate with a lag of about 13 trading days.
Week in Review
Monday: A slew of merger & acquisition (M&A) merger-and-acquistion (M&A) dealmaking activity got the bulls excited in what was otherwise a quiet session for the Yom Kippur holiday. To recap Monday's announcements: Xerox Corp. (NYSE: XRX) will pay $6.4 billion cash for outsourcing provider Affiliated Affiliated Computer Services Inc. (NYSE: ACS), while Abbott Laboratories (NYSE: ABT) will buy the drug business of Belgian conglomerate Solvay SA (OTC ADR: SVYSY) for $6.6 billion in cash. Internationally, Chinese state-owned chemical firm Sinochem Group offered $2.5 billion for an Australian company.
The fact that executives are willing to shell out billions in cash to acquire rivals is a strong vote of confidence in the economic recovery.
Tuesday: A mixed day. The Case-Shiller Home Price Index jumped for the third consecutive month as its 10-city composite gained 1.7% in July. This built on gains of 1.4% in June and 0.5% in May as a combination of ultra-low mortgage rates, tax credits for first-time buyers, and a flood of low priced foreclosures resurrected buying interest.
The bad news as that consumer confidence fell in September as consumers' assessment of current economic conditions remains near historic lows. Some 47% of respondents said jobs were hard to get; up from 44.3% in August. Only 3.4% said jobs were plentiful; down from 4.3%. And finally, nearly 20% said they expect their income will decline.
Wednesday: In its final revision to second-quarter GDP, the government trimmed its estimate of the decline to -0.7% from -1.0% previously. This adds momentum to estimates of a return to economic growth in the third quarter. Separately, the Chicago PMI survey slipped to 46.1, falling back under the dead-even 50.0 mark after reaching it for the first time since 2008 in August. This indicates business activity in the Chicago area contracted slightly in September.
Thursday: A very busy day. The S&P 500 lost 2.6% in heavy selling. Domestic motor vehicle sales plunged to 6.7 million on a seasonally-adjusted annual rate, down from 10.1 million in August as the after-effects of the cash-for-clunkers program were felt. The ISM Manufacturing Index slipped a touch to 52.6 but remained over the key 50 level -- indicating an expansion of activity for the month.
The Week Ahead
Monday: The ISM Non-Manufacturing Index is due. The consensus estimate is for the metric to return to the unchanged level of 50 for the month, which would be an improvement on the 48.4 result form August.
Tuesday: A quiet session with no major economic reports.
Wednesday: The Q3 earnings seasons begins when aluminum giant Alcoa reports results. An update on consumer credit is due from the Federal Reserve. As households continued to reduce an overlarge debt burden, credit outstanding fell by a severe $21.6 billion in July -- the largest fall on record. Analysts expect a contraction of $8.5 billion for August. While increased savings and a reduction of debt outstanding is good for the long-term health of the economy, stocks have been reacting negatively to the news out of fear miserly consumers will threaten retail sales and the economic recovery.
Thursday: The weekly update on jobless claims is due. The measure has been declining at an agonizingly slow rate.
Friday: An update on the U.S. trade balance. The recent weakening of the dollar has provided a nice boost to the competitiveness of our exports. A decline in the trade deficit would contribute to a positive read on Q3 GDP.
Our conclusion: In the last two weeks, investors have reacted with caution to reports of softer economic conditions. That’s caused the U.S. stock market to decline to create the oversold conditions that in the past have led to strength for stocks. But a lot of those worsening conditions – such as lower employment – can actually be positive for corporate balance sheets, since headcount reductions lead to lower expenses. As noted, my expectation is that major tech and industrial companies will create upside earnings surprises and issue positive comments about a stabilizing global economy.
[Editor’s Note: New Money Morning columnist Jon Markman is a veteran portfolio manager, commentator and author. He is currently the editor of two investment-research services, Strategic Advantage and Trader’s Advantage. For information on obtaining a two-week free trial to the daily commentary of the Strategic Advantage, please click here.]
News and Related Story Links:
- Lowry Research Corp:
Official Web Site. - McClellan Market Report:
Official Web Site. - Money Morning News Analysis:
Flurry of Mergers and Acquisitions Drives Stock Market Rally. - Money Morning Week Ahead:
U.S. Stocks: Winning Streak is Over, But Bull Market Continues.