The S&P 500 closed the week at 1,357. Once again it covered a lot of ground, but returned to familiar territory. As we explain below, we consider the 1,335-1,360 range on the S&P 500 as neutral territory that indicates indecision. The Q2 earnings season began after the close on Monday when Alcoa (AA) released its results (see our recap here). The S&P 500 then declined most of the week until JPMorgan (JPM) and Wells Fargo (WFC) released earnings on Friday morning and sparked a relief rally. So far, earnings seem to be in line with analysts' much-reduced estimates. The lowering of earnings estimates has likely been priced in, and now the question is whether expectations are low enough to reflect concerns about the slowdowns in the U.S., Europe, and China.
The relief rally in JPMorgan and Wells Fargo seems to indicate that we reset expectations low enough for these two. However, Friday's price action may just be short covering, so it will be important to watch the next week's reaction to the initial reaction. Also, we've only finished the first week of Q2 earnings season and many more companies are due to release their numbers, providing opportunities to surprise or disappoint. In this week's update we will analyze the price movements in the S&P 500 and other indices, look at a few key stocks, review recent macro news, examine "risk on"/"risk off" indicators, and present a bull and bear case for the market going forward as well as our investment plan.
S&P 500 and Other Major Indices
The S&P 500's Q4/Q1 rally ended in late March. It then traded sideways in the 1,360 to 1,420 range (upper range) until May when it dropped down to the 1,295 to 1,335 range (lower range). Since setting a low in early June it has been rising with higher highs and higher lows, but has not yet climbed above 1,360, into the upper range. We consider the 1,335 to 1,360 area to be the crossroads and represents indecision about the market's direction. If the S&P 500 sustains the move above 1,360, we think that it could retest the 1,420 highs. But if it drops below 1,335, we think it could then retest the June lows.
The following year-to-date chart of the S&P 500 shows these ranges and key price levels.
Source for charts, unless otherwise noted: FreeStockCharts.com.
The price movements in the Dow Jones Industrials Average, Nasdaq, and Russell 2000 were similar to the S&P 500. However, it seems that the Russell 2000 is doing the best to stay in bullish territory. This would be a good indication for the overall market since outperformance of smaller stocks generally indicates a good level of risk appetite. However, this is not confirmed by the Nasdaq, which is also considered more risky than the S&P 500 and the Dow.
Spotlight on Key Stocks
We consider the Q4/Q1 rally to be the "Apple (AAPL) rally." Similarly, we think of the current environment as the "Wal-Mart (WMT) market." We noted several times in prior updates that Wal-Mart was approaching all-time highs after trading in a range going back to 1999. Allegations of bribery in Mexico caused a drop in late April, but Wal-Mart has since sustained an uptrend.
Wal-Mart's rise seems attributable to two factors. It caters to the low end, which is treated as a safe haven in the current environment. Also, it is a large cap with a reasonable P/E and a dividend yield of 2.17% (even after the recent run-up). Investors seem to be favoring a steady, yield-generating stock like Wal-Mart over more risky areas of the market.
While Wal-Mart's rise to record highs may be overdue following a decade long period of strong performance and multiple compression, we are not sure that it indicates strength for the market. The following charts show Wal-Mart's performance over the last year and going back to the 1990s.
By contrast, Apple has been trading sideways since its Q1 earnings release. Apple has climbed over the last few days, but it will be interesting to see the reaction to Apple's Q2 earnings and if the stock price will again make new highs. Apple is the largest component in the S&P 500 so we think that its price movements have added significance for the market.
While investors are shifting their focus to company earnings, there were a few interesting pieces of macro news last week.
China announced that Q2 GDP grew at 7.6% in Q2, which was in line with expectations. There was good coverage of this on FT Alphaville and Bloomberg, especially the questions about the quality of the data in the context of flat electricity output. We are never sure how to interpret Chinese figures, but a growth rate of 7.6% will give investors an excuse talk about the China slowdown. However, if everything in China is engineered, then the recent interest rate cuts may indicate a desire to accelerate growth, which will be reflected in future numbers.
The China slowdown story may also be the cause for the slowdown in Singapore. Singapore announced that Q2 GDP was down 1.1%, compared to expectations of a 0.6% gain. Similarly, South Korea's central bank unexpectedly cut interest rates as well as its 2012 growth forecast.
Risk On/Risk Off Indicators
The correlations of the risk off trade components have weakened as some have rebounded, but we are still following these indicators. Investors are now more focused on earnings than Europe, but that doesn't mean that the European situation is resolved. In fact, the euro has been falling to new lows and Spanish and Italian bond yields remain elevated. Similarly, U.S. treasuries climbed. On a more positive note, oil halted its decline and the VIX is down.
The euro closed at a new 52-week low after briefly falling below 1.22. The revised bailout of Spanish banks initially provided support to the euro, but it resumed it downward trajectory and seems to be headed lower.
Moody's downgraded Italian debt this week. Interestingly, following the downgrade Italy sold bonds at a lower yield then in previous auctions. Still, the yields on the Italian and Spanish 10-year bonds remain elevated and are a source of concern.
The following charts are for the 10-year bonds of Italy and Spain, respectively.
The U.S. 10-year bond closed the week at 1.49%, and the decline in yield indicates that investors are favoring the safety of treasuries. The 10-year now seems positioned to retest the record low yield from early June. The iShares Barclays 20+ Year Treasury Bond ETF (TLT) tracks U.S. bond prices and shows the recent move in treasuries.
WTI Cushing crude oil closed the week at $87.10 per barrel. We are very interested in hearing the comments from CEOs of energy companies over the course of earnings season to understand if the recent drop in oil impacts their plans and if they believe it will rebound soon. Oil fell to the $80 per barrel range in August 2011 and traded sideways for a few months before bouncing back. The current price could be a good entry point for oil and energy company stocks.
We are not sure if the recent bounce indicates better sentiment about the global economy or if it just means that oil fell to a price that would cause some production cuts, or the anticipation of production cuts.
Finally, the VIX - CBOE Volatility Index closed the week at 16.73. The fall in the VIX to below 20 is a good sign for the market and may also be a good opportunity to go long volatility as a hedge or as a bearish position.
The Bull Case
The bull case assumes that the market will continue to move higher based on positive earnings surprises or, at least, companies meeting reduced expectations and giving an positive outlook for the second half of 2012. Analysts may have reduced estimates too much and the current pessimism may be overdone. It is hard to forecast if this is correct, but we will know more over the next few week.
The earnings reports from JPMorgan and Wells Fargo were encouraging and the CEOs of both companies made positive comments about the economy. Considering that valuations are low or, at least, reasonable, some positive news could spark a rally -- at least to the upper range of the recent price action that we discussed above.
The Bear Case
On the flip side, earnings could disappoint. There have already been a lot of earnings disappointments, especially among smaller companies. And the stocks of companies that have missed earnings have been treated harshly by investors.
Even if the market holds up through earnings season, it will need to deal with the U.S. election and the fiscal cliff later this year. The European crisis may resurface and it does not seem to have really gone away yet. There are a number of catalysts on the horizon that could derail the market.
Two weeks ago we titled our update "Buying Stocks Because Expectations Are Low" and said that we favored buying the S&P 500 in the low/mid-1,300 range. We did not fully execute on this plan for two reasons. The S&P 500 has not spent a lot of time in the low 1,300s (though it has been in the mid-1,300s). Also, there were a lot of companies that reduced their earnings guidance significantly and the negative market reaction to the earnings disappointments gave us some pause.
We made a few purchases of individual stocks. However, the accumulation of negative guidance caused us to re-examine our portfolio and we sold some positions in companies where we didn't want to have risk going into earnings. This was especially true in the financial and technology sectors.
We still have a bullish bias, but we are taking a wait-and-see approach to earnings. We may miss a few post-earnings pops, but if the market moves higher then we will be able to capture enough of the move after earnings.
One of the reasons that we favor the S&P 500 in the low/mid-1,300s is that we could set a stop below the June lows and limit our downside. Considering all of the macro concerns, we think that it is important to employ a stop strategy to limit losses on all positions.