The market has been consolidating for the last month. From June through the middle of September, it rallied 15%. After a big run like that, it needed time to gather strength. Traders have been searching for the next driver and they will get it next week as earnings season kicks into high gear.
Alcoa, Yum Brands and Costco got the ball rolling this week. The numbers were better than feared. Wells Fargo and J.P. Morgan Chase will release tomorrow morning. I believe profits will be strong and the reaction will be positive. Financial stocks have been leading the charge and European credit concerns remain subdued. Big banks and tech will dominate the scene next week.
Warnings from PC makers have weighed on the entire tech sector. Intel, IBM and eBay will post the results and they will stop the bleeding.
Across all sectors, revenues will be light and guidance will be cautious. Earnings season won’t excite investors, but it will calm nerves. The next rally will be based on valuation.
The S&P 500 has a dividend yield of 2% compared to 1.7% for US 10-year treasuries. Bond yields are at historic lows and as long as European credit concerns remain low, money will shift out of fixed income and into equities. Large money managers (like PIMCO) are buying Spanish debt. The ECB has stated that it will do everything necessary to avoid a financial crisis. Spain will officially request aid and Greece will get its next payment. Both of these events will be bullish.
Stock valuations are attractive and the S&P 500 is trading at a forward P/E of 14. Corporate balance sheets have never been stronger. Cost cutting has preserved profit margins and companies are running lean and mean. Any future uptick in revenues will go straight to the bottom line.
The economic releases have also been bullish (ISM manufacturing/services, ADP, factory orders and the Unemployment Report). This morning, initial jobless claims fell to 338,000. That was much better than expected and employment conditions are gradually improving. There won’t be any major economic releases next week and earnings will be the focal point.
As I’ve been mentioning, China will initiate fiscal spending programs and the PBOC will ease. This week the central bank provided a massive liquidity injection and overnight the government announced that fiscal spending would increase by 20% in the next three months. This is the fourth consecutive raise in the last quarter. They are preparing for a leadership change (happens every 10 years) and they want to make sure the transition goes smoothly.
Investor sentiment has been very bullish and speculators needed to get flushed out. I believe that has taken place this week. Asset Managers have been waiting for a dip and this might be all they get. With each passing day the bid will strengthen because they don’t want to miss a year-end rally.
The SPY broke through resistance at $143 in September and now that level represents support. I believe it will hold and we have tested it a second time.
The reaction to Wells Fargo and J.P. Morgan Chase tomorrow will be very telling. If the stocks rally on the news, I will allocate the final 25% of my capital. I have been scaling in during the last two weeks. If the reaction is muted or negative, I will watch for support next week.
I’ve been telling you to scale in and I suspected some nervousness ahead of earnings season. When you gradually add to positions, pullbacks don’t seem as daunting.
This morning the S&P 500 is up nine points in early trading. Yesterday’s losses should be wiped out early in the day. The late day selling pattern should be broken in the next few days. There will still be some nervous trading next week, but the price action will be positive.
All of the pieces are in place for a nice year-end rally. Get long.