It is always interesting when the gap between perception and reality is filled. While markets usually trade on fundamentals and valuations longer-term, daily and weekly news often moves the market significantly in the short-term.
The S&P 500 and its tracking exchanged traded fund, SPY (NYSEARCA:SPY), has rallied for nearly three months now, with cyclical sectors such as energy, the industrials, and the financials, up over 10% since early June.
Still, as impressive as the recent two month rally has been, the market is still below its early April highs.
This is why I think the market's recent rally over the last couple weeks has been so interesting. The S&P 500 and Nasdaq finished this past week up strongly, with both indexes up nearly 2% on Friday after Draghi's statements were reinterpreted and the above-expectation jobs report.
The first reason why the market will likely have trouble moving forward is that cyclical stocks are likely pricing in unrealistic growth expectations. I've been bullish on many market leaders in cyclical sectors such as GE (NYSE:GE), Caterpillar (NYSE:CAT), and engine maker Cummins (NYSE:CMI) for some time. Still, these companies have rallied over 10% from their June lows, and GE and Cummins have rallied over 15% in the last six weeks.
While most major industrial companies have reported solid earnings, management has not raised guidance, and these stocks do not look cheap at today's levels. Companies on longer-term business cyclicals such as GE and Boeing (NYSE:BA) now trade at around 13x average estimates of next year's estimates, and companies on shorter-term business cyclicals such as Caterpillar and Cummins now trade at nearly 10x average estimates for next year's likely earnings.
Even though historically these multiples are cheap, with most analysts projecting mid-single digit growth for these companies and the U.S. economy growing at less than 2%, valuing cyclicals at more than 13x forward earnings seems overly optimistic. If the macroeconomic situation improves, multiples will obviously expand. Still, the recent jobs report was not a game changer, with unemployment actually rising, and companies with mid-single digit growth rates and minimal dividends are unlikely to trade at more than double expected growth rates. Caterpillar and Cummins both issued fairly cautious guidance, and these companies' recent earnings suggest that most major emerging markets remain very weak.
The second reason the market will likely have difficult rallying further is a lack of leadership. While financials and industrials led the nearly six month rally from the summer lows of 2011, Apple's (NASDAQ:AAPL) recent earnings miss and the weakness in the eurozone has limited short-term expectations for the market leaders. While, clearly, Apple is expected to ramp up earnings with its blockbuster iPhone 5 launch, the company is not planning to reveal the hotly anticipated new phone until mid-September. The company's very poor recent sales in Europe also suggest estimates may be too high for the fourth quarter as well.
The third reason the market will likely have trouble continuing to rally is because of technical resistance. While the S&P 500 and Nasdaq have rallied fairly consistently over the last two months, the S&P 500 will likely face significant near-term resistance at 1420 level the market topped out at in early April, and the Nasdaq will also likely face significant resistance at around 2700. Major companies in each of the major indexes, such as GE and Apple, are also now less than 2-3% percentage points off these stocks fifty-two week highs.
To conclude, while Draghi's recent discussion of possible further quantitative easing efforts and the job report helped continue the impressive two month rally, the growth outlook has not significantly improved. While short-covering and low expectations have helped fuel the recent rally, emerging markets remains weak, as most companies issued fairly cautious recent guidance. With the ECB facing significant political and legal constraints to possible new stimulus efforts, and the U.S. economy still growing at less than 2%, longs will likely wait before initiating significant positions.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.