Will Q2 Earnings Spark a Rally?

 |  Includes: DIA, QQQ, SPY
by: Sy Harding

The stock market is down 16% since its April peak, getting close to a decline of 20%, the threshold of entering a bear market. The S&P 500 is already back to its level of early September, having given back 38% of the entire bull market off the March low last year.

Yet, while investor sentiment has turned more pessimistic, it has held up surprisingly well in the face of the market decline, the steady stream of negative U.S. economic reports, and the continuation of troubling news from Europe and Asia.

This week’s poll of its members by the American Association of Individual Investors showed a rise in the percentage of investors who are bearish, but at 42.0% still well below the 50% to 60% bearish level almost always reached before corrections end.

As each disappointing economic report for May and June came out and sent the market lower, there was always another report yet to come that investors could hang hopes on, keeping them bullish.

When it was reported that retail sales fell in May, Wall Street provided assurances that consumer confidence would be up for June, which would indicate the May decline in retail sales was just a blip. When consumer confidence instead showed an unexpected drop in June, there was still Durable Goods Orders and the ISM Manufacturing Index due out in a few days that would show that manufacturing growth was still strong. When those reports also showed declines, there was hope the employment reports would show a healthy pick up in new jobs created in June. When the first of those reports, the ADP report, was released on Wednesday and was a disappointment there was still hope that Friday’s BLS jobs report would be encouraging. But it was not.

Even the most bullish economists have expected economic growth to slow in the second half of the year. But the onslaught of negative economic reports for May and June provide considerable evidence that the economy is slowing sooner and faster than previously expected. That has raised concerns that it may be a more serious slowdown, perhaps back into recession, that the best hope might be for a W bottom rather than the previously expected V bottom.

My original projection in the spring was that the market would experience a significant decline of 15% to 19% in its unfavorable season this year, but probably not a new bear market. But here we are, with the S&P down 16% and the Nasdaq down 17%, and looking like the market has further to go on the downside.

My biggest concern is the collapse of the housing industry in May once the rebates to home-buyers expired, but also that global economic problems seem to only be in their beginning stages, their effects still to reach our shores, while the U.S. economy is slowing faster than expected on its own. Keeping investors’ hopes alive now is the expectation that second quarter earnings reports, due to begin next week, will be impressive and provide support for the market.

Wall Street and corporations have become experts at keeping their estimates and guidance low enough that they are not huge hurdles, and the comparisons will be easy since they will be comparisons to the second quarter of last year, which was just about at the trough of the recession. But then I look back at the last two earnings reporting seasons, and there is cause for concern.

The January/February correction earlier this year began mid-January when the impressive earnings reports for the fourth quarter of last year began coming out. The stocks of many of the companies reporting the best sales and earnings gains actually ran into the most selling and profit-taking.

Similarly, the current market correction began in mid-April just as the first quarter earnings reports began coming out. Once again, even though the reports were positive, and for the most part exceeded Wall Street’s estimates, the market rolled over into this even more serious correction. And again many of the companies with the most positive reports ran into the heaviest selling and profit-taking.

As second quarter earnings reports begin next week it’s even more obvious the economy is slowing, so even more possible that the top for earnings growth has arrived. The market is again short-term oversold, and probably due for another short-term rally attempt, which will bring hopes for a summer rally. But I’m not ready to turn bullish yet. Let’s see those Q2 earnings reports and how the market reacts to them.

Disclosure: No positions