Issue 33 • JULY 15, 2009

Where’s the Beef?

The stock market rally has hit something of a “speed bump” recently, with the swift upside ascent from March through May giving way to a sideways trend since about mid-June.

This week, we enter the heart of second-quarter earnings season, which may hold the key to the future direction of markets. There’s certainly enough positive speculation swirling on earnings that markets could push higher, but is this sustainable?

Up until recently, much of the rebound rally in stocks was attributed to improvement in the so-called “second derivatives” of the economy ... that is to say, conditions moved from bleak to somewhat “less-bad.”

But, for the economy and financial markets to transition into a true, sustainable recovery ... we’ll need to see something more than “green shoots” that are merely less bad!

The Head & Shoulders Market

The recent market rally was head and shoulders above anything we have seen before during this bear market. The S&P 500 Index jumped nearly 40% from its March lows, leading many investors to conclude that we just may have entered a new bull market phase.¹

In June, however, the new “bull market” took a breather, perhaps not surprising after such quick and sharp gains. Since the June peak, stocks have now corrected about 8%, forming a “head and shoulders” top along the way.²

A head and shoulders top is a classic formation in technical analysis (see graph). It typically occurs when the market rallies to a higher peak (the head) than it reached before (the left shoulder), but usually on lower volume than before.

The market then pulls back again to roughly the same level as the previous low, then attempts to rally again, but this time it falls short of making a new high (the right shoulder) while volume declines even more.

When a head and shoulders top is violated, with prices dropping below the “neckline” formed by the previous lows — this is typically seen as a bearish signal that the market advance is over, and stocks are likely to decline further ... but not always. After all, no indicator is correct all the time.

Last week, stocks dropped briefly below the neckline — undercutting previous lows from May and June — roughly below a range of 880 to 890 for the S&P 500. But this week, stocks are rallying again. So the question now is: where to next? Enter earnings season and the ongoing debate over “green shoots.”

Round Up for the Green Shoots

As the second quarter profit reporting season gets into full swing this week and next, the big thing to keep an eye on is ... not so much the actual numbers being reported ... but instead, the forward-looking guidance provided by management.

In other words, how much a company did earn from April through June is not nearly as important as the outlook on how much they expect to earn going forward.

If the economy is to enjoy a robust and sustainable second-half rebound, then businesses should be among the first to see this happening in terms of an improving sales and profit pipeline for the third- and fourth-quarters.

It stands to reason that if the majority of S&P 500 companies deliver positive guidance for second-half results (as opposed to just “less bad” guidance), then the stock market’s spring rally could receive some much needed fundamental fertilizer, and continue to take root ... perhaps even resuming the rally through year end.

But companies could also spray RoundUp all over these green shoots if they issue negative forward-looking guidance — or worse, if they don’t have much “visibility” at all.

Searching for a Sustainable Rebound in Sales and Profits

Earnings expectations have been raised significantly in recent months as a result of the less-bad data ... now investors will be rightly asking, “Where’s the beef?”

This creates major downside risk for the market. That’s because meeting these inflated second-half earnings expectations could prove difficult for companies still operating in an economy that is struggling against strong deflationary currents.

After a recession, it typically takes two to three years for earnings to fully rebound back to trend ... and, need I remind you that this has been NO ordinary recession?³

It’s not all about earnings either. The bottom line can temporarily be dressed up through cost-cutting (not to mention accounting gimmicks) to appear much better than reality ... but not forever.

That’s why it’s important to watch top-line sales growth even more closely. During the first quarter, over 60% of S&P 500 companies beat (lowered) profit forecasts, but when it came to top-line sales, only 46% beat sales forecasts — fewer than any other quarter since 2002.⁴

To be sure, investors will be looking for strong second-quarter profit performance, but if top-line sales results don’t also beat expectations, it could be an early-warning of trouble ahead for stocks.

Not to be deterred, Wall Street’s always-optimistic analysts see second quarter profits falling ONLY -17% from the same period a year ago. Of course, this is considered less-bad than results posted in the first quarter, when S&P 500 firms experienced a -39% plunge in profits.⁵

Better still, Wall Street now expects full-year 2009 earnings to be UP +12% over the dismal results recorded last year ... and 2010 profits are forecast to zoom +34% higher!⁶

These forecasts are, of course, entirely dependent on a spectacular rebound in corporate profits during the second half of this year and beyond ... hence, the importance of focusing on forward-looking guidance from companies over the next several weeks.

This all-important guidance could either confirm or kill off this particular green shoot. Stay tuned!

Good investing,

Mike Burnick
Director of Research & Client Communications
Weiss Capital Management, Inc.

¹ BlackRock Investment Commentary, 7/13/09
² Ibid.
³ Financial Times: Weeds start to sprout among the green shoots, 7/14/09
⁴ Ibid. and Bespoke Investment Group: 62% Is The Magic Number, 7/9/09
⁵ Standard & Poor’s data, 7/7/09
⁶ Ibid.