Stocks Will Rise in Short-Term, Strongest Headwinds Will Be From Earnings

by: Yatin Karnik

U.S. stocks were wacked around on Friday afternoon as the U.S. dollar broke down, with the Dow Jones industrial (NYSEARCA:DIA) average down 26.44 points, or 0.24%, to end the day at 12,380.05. The S&P 500 (NYSEARCA:SPY) Index was fractionally lower by 5.34 points, or 0.40%, to finish the day at 1,328.17. Nasdaq (NASDAQ:QQQ) was down 15.72 points, or 0.56%, to close at 2,780.42.

CNBC recently conducted a Fed survey, which included economists, fund managers and strategists. Here are some key points from that survey:

  • About 27 percent believe the Fed will begin selling assets in the second half of 2011, to reduce the size of its portfolio, up from around 16 percent in the prior survey.
  • Slightly more than half of the 69 respondents believe Fed policy is now "too accommodative," up from 44 percent in March.
  • The percentage who believes the Fed has policy "just right" declined to 42 percent from 50 percent.

If a marginal number of economists, fund managers and strategists think that Fed is going to start raising rates, if not this year, early next year, then why is the stock market still going up? The outlook for a third round of quantitative easing remains muted, but as long as Fed does not raise rates substantially, policy supports higher asset prices. Commodity prices are supported by the fact that real interest rates are negative and will remain negative even after Fed raises rates early next year.

U.S. stocks have been in a strong uptrend for almost four weeks now. I believe there is not more room for stocks to run further. But it would not be surprising if the stock market acts a little heavy. It is entirely possible that stocks will mostly consolidate for the week ahead. Stocks might also take a definite direction midweek, when the House and Senate are expected to vote on a budget for the remainder of this fiscal year. Some Tea Party members believe that it might be very difficult to gain consensus on the budget unless Democrats concede. But Democrats are showing no signs of giving in just yet. Obama will also reveals his plan to reduce the deficit, in part by scaling back programs for seniors and the poor. Around 10PM on Friday, just hours before theatrical government shutdown, both parties came to an agreement to fund the government through this week. House members of both parties who voted for the funding through the week could not say on Sunday that they'd vote for the plan to fund the government through September.

Most of the companies in the Standard & Poor's 500 index have surpassed analysts' profit expectations since 2009, or eight straight quarters. Contrarians think the reason is low expectations from analyst in midst of a recession. But some analysts say they will make it nine straight this earnings season, which begins Monday with earnings report from Alcoa Inc. (NYSE:AA) and then J.P. Morgan (NYSE:JPM) on Wednesday. As we know, stocks are priced on the assumption that earnings will meet expectations. If results beat forecasts, expect stocks to go up. On the other hand, if company results don’t meet expectations, we have tougher days ahead.

In my opinion; stocks will rise in coming weeks but in the very short term the greatest headwinds will come from earnings season. It will be interesting to see the impact of earthquake in Japan for companies that draw revenue from that country. Unless companies beat analyst expectations, I think market will tend to go lower. I think the bias of the market, if these companies start missing earnings forecast, would be to the downside. If you are a believer of the market as most of the analysts on the street are, then you should own the market at this juncture. To benefit from climb in S&P you can get long exposure to SPY or SSO (ProShares Ultra S&P). You could also benefit by getting short exposure to SDS (ProShares UltraShort S&P). In case the S&P breaks out to the upside; I have no reason to believe that Dow Jones Industrial average won't make new highs. To benefit from rise in Dow, I recommend getting long exposure to DIA or DDM (ProShares Ultra Dow). You could also double the return from rise in Dow Jones Industrial from getting short exposure to DXD (ProShares UltraShort DOW).

For more experienced traders who want to bet on specific segments within the S&P index, there is IVV (that tracks large-capitalization U.S. stock market performance), MDY (that tracks the S & P MidCap 400 index), IWM (that tracks the Russell 2000 index) and IJR (that tracks S & P SmallCap 600 index).

Disclosure: I am long SPY.