S&P 500 (NYSEARCA: SPY) is perched near the top, but market participants have been left bewildered by the "unusual" calm in the market post its breakout. S&P 500 has gone absolutely nowhere in the last 5-6 weeks after a strong bullish move.
Q2 earnings season is almost over with 498 companies having reported. And it turned out to be better than expected.
According to a report from FactSet, the blended earnings decline for the S&P 500 is -3.2% for Q2, which is much better than the estimated decline of -5.5%. However, this marks the first time that the index has recorded five consecutive quarters of year-over-year declines in earnings since Q3 2008 through Q3 2009.
Looking ahead, the Q3 bottom-up EPS estimate has dropped by 2.5% to $29.88 from $30.64. This might look disappointing in isolation, but from a historical perspective, this is actually better. During the last 4 quarters, the average decline in the bottom-up EPS estimate during the first two months of a quarter has been 3.9%. During the past five years (20 quarters), the average decline in the bottom-up EPS estimate during the first two months of a quarter has been 3.4%. During the past ten years, (40 quarters), the average decline in the bottom-up EPS estimate during the first two months of a quarter has been 3.8%.
As the market is clearly disconnected from the earnings and more focused on liquidity, it wouldn't be surprising to see the index head higher. The U.S. economy seems to be in a better shape than other developed economies which are still experimenting with quantitative easing, helicopter money and negative interest rates, while the U.S. Fed is contemplating raising interest rates not once but twice in the next 12 months. Here, let us not ignore the possibility that once interest rates go up by, say, 50 bps, liquidity will be reduced, and the market may then come to value earnings more. This is just my theory.
Whether stocks will then correct is hard to say, but I want to attempt to put forth a possible scenario. As we are talking about the future, my assumptions can be off the mark, so please do your due diligence.
The chart below shows sector-wise S&P 500 earnings growth. From the first look, it seems that every sector is performing well except materials (NYSEARCA: XLM) and energy (NYSEARCA: XLE).
The outperformance in these sectors was marked by "earnings beats," which might be good to hear, but is actually a high-level rigged game. The managements and the analysts are hand in gloves in attaining these beats. An interesting piece on how managements actually beat the market estimates, and how rigged Wall Street actually is, can be read here.
Apart from this, I do not want to plainly look at the growth numbers and be happy about them. I want to know and understand how the growth was achieved. Is it a one-time event or is it sustainable? Is the growth coming from all companies or is there a single big player dragging the whole cartel forward?
To explain this, I will use the Telecom sector from the chart above. Telecom sector earnings grew 7.2% in Q2, the second highest earnings growth. But behind this number is a grim reality. Of the five companies in the sector, the majority of growth has come from only one company: AT&T Inc. (NYSE: T), which benefited immensely from DIRECTV. If AT&T is excluded, the earnings growth drops steeply to -5.7%.
On the other hand, all six industries in Health Care reported strong revenue growth numbers, led by Health Care Providers & Services (11%) industry.
Celebrating The Liquidity While It Lasts
I am of the opinion that the market will celebrate cheap liquidity while it lasts, and therefore, any or all earnings disappointments will be short-lived. The bulls would want to force the market to new all-time highs before the November U.S. presidential elections.
Technical charts also indicate that some fuel is left in this rally.
First, the monthly SPY price chart below indicates that the indicators - Money Flow Index and Relative Strength Index - have bottomed out, and are on their way up.
The weekly SPY price chart indicates that the index had been oscillating in a 30-point range for more than 18 months until it finally broke out on the upside. The support for the range was approx. 182.50 while the resistance was 212.50. The breakout from long-term consolidation is unlikely a fake one and the market can be expected to touch 240 in the next one year.
I have evaluated some stocks which can benefit from the coming rally, on the basis of technical as well as fundamental analysis. I have provided below the analysis of those stocks sector-wise.
The possibility of a market rally should not necessarily be taken as advice to go long. One can also use the coming rally to book profits, and reduce exposure.
Q2 may have been better than expected, but the earnings are still declining. I believe that this may be the last run up of the bull, and therefore, I am planning on reducing my exposure to stocks. I risk being wrong (missing out on a rally) if the market continues to fly even higher than the 240-level target I gave above.
Different participants have different risk appetites, and different time horizons for investment. I am a very risk-averse investor.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.