Weighing the Week Ahead: Earnings vs. Economy

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 |  Includes: AAPL, BAC.B, CAT, DIA, GS, IBM, QQQ, SPY
by: Jeff Miller

Corporate earnings have become even more important. This week we will see reports from many of the big names including Apple (NASDAQ:AAPL), IBM big financial names like Bank of America (NYSE:BAC) and Goldman Sachs (NYSE:GS), and some of the key industrials, including Caterpillar (NYSE:CAT).

In recent years macroeconomic issues have dominated the analysis of investment strategy. The high correlation of all stock and commodity trades has led to a typical Wall Street simplification: "Risk on, risk off." Daily trading is usually inversely correlated with the dollar.

The economy and the equity market have followed quite different paths in 2010. Most recently, stocks have moved higher while economic news shows no improvement. The prevailing explanation is that the Fed is coming to the rescue with more quantitative easing.

Meanwhile, corporate earnings have improved dramatically. Skeptics have challenged the continuing growth potential -- how much can costs be cut? -- but the naysayers have so far been proven wrong. We now see actual revenue growth, perhaps 7% or so, and earnings growth exceeding 25%. Current earnings are good and forward earnings (worth your attention, as I showed here) are even better. Some savvy observers see plenty of upside for the remainder of the year.

The battle between the mediocre economic news and the exciting earnings news comes into focus during the earnings reporting season. We should all pay attention.

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.

In most of my articles I build a careful case for each point. My purpose here is different. This weekly piece emphasizes my opinions about what is really important and how to put the news in context.

Last Week's Data

The economic reports last week did little to change the overall picture of a slowly growing economy. As usual, Calculated Risk has a nice summary including some great charts.

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.
  • Early earnings reports were solid, including positive comments on the business environment. Check out this optimistic look at the early returns.
  • Fed openness, demonstrated in Bernanke's Friday speech, is a little-understood positive. Here is why. There is a problem with the increased monetary base turning into actual lending. The Fed can help this problem with better communication. James Hamilton's work is always worth reading, and this article is especially important.
  • Good humor from Barry Ritholtz. Enjoy the PermaBear to English translation guide. (My personal favorite is the Hindenburg Omen, but there are plenty of laughs). We are all waiting for the PermaBull version, but this will be hard to top.

The Bad

The economic news was basically more of the same. The factors related to signficant improvement in employment where unimpressive.

  • Initial jobless claims moved a touch higher. While we no longer see the five-handle that was probably a seasonal factor, fresh job losses seem stuck at about 450K per month. Not good.
  • Small businesses remain pessimistic, with fresh hiring weak. This is important for job creation.
  • Consumer confidence remains poor. This factor reflects captures both job losses and job creation.

Bernanke's speech captured reality pretty well. We have a modestly growing economy that is good for some, but still feels like a recession for many. Below trend growth is not acceptable to most people nor to the Fed.

The Ugly

The continuing story on issues with mortgage foreclosures is a threat of unkown size. It is worth watching carefully. There has been good coverage from several sources, including Yves Smith, Calculated Risk, and James Kwak. I am reading all of them and following the links as well.

Investors must decide whether this is a probability that can be addressed with relative ease, the extent of the impact on financial stocks, and whether there can be an overall economic shock.

The Week Ahead

The market has continued to improve in tone, but the reasons are troublesome. Daily gains relate to a weaker dollar. Economic weakness is excused as more evidence that the Fed will act aggressively.

The Fed Beige Book provides anecdotal evidence for the FOMC meeting. Some think it will shed light on the prospects or size of Quantitative Easing, but that is not likely.

We will see some new housing data, including building permits -- my favorite early indicator.

I prefer to base decisions on fundamentals like corporate earnings. That will be my focus for the week. And finally, Bespoke Investment Group highlights the top earnings stories for the week. Print out their helpful chart to see the earnings beat rate for a list of important stocks.

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:

  • 91% of our 55 ETF's have a positive rating, up from 87% last week.
  • 25% of our 55 sectors are in our "penalty box," up from 9% last week. This means that there are many attractive sector and stock opportunities, but there is greater risk in many sectors.
  • Our universe has a median strength of +32, up slightly from +25 last eek.

For trading accounts, we had full exposure during the past week, continuing to catch the recent rally.

[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.]

Homework

There is a great reward for doing your homework. Last week I suggested that the financial media should require a test before inviting guests to comment on Quantitative Easing. In the absence of such a screening device, the discerning listener or reader needs a little information. Bob McTeer provides a simple, non-technical explanation that deals with most of the simplistic comments. Vince Rinehart is a bit more optimistic about the likely results. If you spend five minutes with these two articles, you will know more than most of those swinging out of their "happy zones." No one really knows how aggressively the Fed will act, nor how effective the policy will be, but you can steer clear of the myths and simplistic arguments.