Market Update: Q1 Earnings Are Not The Catalyst Investors Are Looking For

Includes: AA, AAPL, IVV, SH, SPY
by: Pendulum

This time is different, at least so far. Back in January the stock market rallied through the Q4 2011 earnings season. On January 9, Alcoa (NYSE:AA) released its Q4 results, marking the beginning of earnings season, and the S&P 500 continued its rally over the following weeks and months.

The market is now reacting differently to earnings. The S&P 500 peaked a few days before the release of Alcoa's Q1 earnings on April 10. Since then, the market has been in neutral and has not yet returned to its highs.

In general, earnings have been OK. There has been a lot of talk about the lowering of earnings estimates, which makes it easier for companies to beat expectations without indicating strength for the economy and the stock market. Nonetheless, earnings have generally been positive, even if they are benefiting from the perception of lowered expectations.

It seems that the market's reaction to earnings is an example of the "buy on the rumor, sell on the news" phenomenon. Investors may be using this earnings season as an excuse to reduce risk and lock-in gains after the market rally over the last few months. So far, this earnings season has not been a catalyst for additional upside like it was in January.

Apple (NASDAQ:AAPL) is a good example of this general trend. The chart below shows Apple's stock price and the vertical lines indicate the company's Q4 2011 and Q1 2012 earnings release dates. Apple rallied following Q4 earnings to new highs, but fell in advance of Q1 earnings. Since the release of Q1 earnings, Apple has bounced back to the $600 per share range, but is still below all time highs. It will be interesting to follow Apple to see if investors will drive the stock price higher after becoming more optimistic after the release of the Q1 numbers.

In addition to corporate earnings, two other significant macro drivers for the market are Europe and the Federal Reserve.

Late last week, S&P downgraded Spain's debt. Interestingly, the US market was up following the news. We believe that the market had already factored in the downgrade and S&P was again late in reducing its credit ratings. Earlier, the market declined as Spain's 10 year government bond yield again reached 6%, an indication that investor concerns about the situation in Spain are intensifying. We think that the mess in Europe is a significant risk for the market, especially with Spanish bond yield in the 6% range.

The Federal Reserve conducted a policy meeting last week. Significantly, the next policy meeting will be at the end of June around the time that the Federal Reserve's Operation Twist is set to expire. Operation Twist was designed to help reduce long term interest rates and there have been some concerns that without further action from the Fed the economy and/or the stock market would weaken.

The Federal Reserve hinted that it would be open to an additional round of quantitative easing (policy to reduce interest rates) if the economy would worsen, but it did not guarantee such a move. In fact, the statements following the meeting were vague enough that everybody found something to like and dislike. The Federal Reserve has acted as a crutch for the market for the last few years. It is possible that the lack of Fed action will lead to market declines.

The bottom line is that we continue to remain cautious. Corporate earnings have not acted as a catalyst to new market highs. At the same time Europe is creating downside risks and the Fed may disappoint as well. The market may need to take a break for a few months following the rally in Q4 and Q1. Should that happen, then the S&P 500 could continue to trade in the 1,350 to 1,450 range. The market may break above this range with increased confidence about corporate earnings or below if the risks mentioned above materialize. Until then, we think that the market is taking a pause.

Disclosure: We have a position in the ProShares Short S&P 500 ETF (NYSEARCA:SH). We may trade this position or the stocks mentioned in the article in the next 72 hours.