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Earnings will hold the key for stocks

We have two classes of forecasters: those who don’t know – and those who don’t know they don’t know.

-John Kenneth Galbraith

After the stronger than expected jobs report on Friday and ahead of the much anticipated earnings season beginning on Monday, many market pundits and economists have begun to forecast those earnings as well as the timing of the reduction in the Fed stimulus program. The consensus estimate calls for earnings growth to be rather weak, with earnings and revenues expected to rise less than 3% for the second quarter. So far earnings pre-announcements have been extremely negative, with the ratio of negative to positive comments running at 6.5 to 1. Prior to Friday’s positive jobs report, most economists had expected the Fed to begin tapering its bond-buying program by year-end. Now most economists, fund managers and investment strategists expect the central bank to begin tapering as early as September or October. Obviously, this earnings season is particularly important as it could determine the future direction of stocks in a world without any central bank assistance.

Last Week 

As investors closed out the first half of the year last week, the news on the economic front was generally positive. Home construction spending was at the highest level in more than four years. That positive news was offset by the fact that the interest rate on a 30-year mortgage rose to 4.5%, which could reduce refinancing activity and could weaken demand for housing. As a precursor to the jobs report on Friday, both the ADP jobs report for private companies as well as the weekly jobs claims number indicated that the job market continues to slowly improve. The employment report itself was better than expected as 195,000 new jobs were created, compared to the consensus estimate of only 165,000 new jobs. To show how difficult the forecasting business can be, the jobs created in both April and May were revised upward by a total of 70,000, which increased the six month average to 202,000. 

While stocks applauded the news on the jobs report, the bond market sold off as fears rose that a stronger economy would lead to Fed tapering sooner rather than later. The yield on the 10-year Treasury climbed to 2.7% and prices on bonds fell on the news. In other parts of the world, the European Central Bank (ECB) reiterated that it plans to keep interest rates low for an extended period of time and the Bank of England repeated its stance that market pricing of future rate increases was unjustified. In Egypt, President Mohammed Morsi was ousted from power by the military and amid the tumult, oil prices spiked above $100 a barrel. And in Portugal, the resignation of the foreign minister and the uncertainty it might bring to the country led to a plunge in stock and bond prices.

For the week, the Dow Jones Industrial Average rose 226 points or 1.52% to close the week at 15,136. The S&P 500 actually did slightly better as it rose 26 points to end the week at 1,632, a gain of 1.59%. The technology-laden Nasdaq jumped 76 points for the week to finish at 3,479, an increase of 2.72%. 

This Week 

This week the focus will be squarely on corporate earnings as Alcoa begins the hit parade on Monday. Not only will investors be keeping an eye on earnings season, but they also will be wary of action in the bond market and the possibility of still rising interest rates. There are a number of economic reports scheduled to be released this week, including data on import prices as well as producer prices. Consumer sentiment and consumer credit are also on tap, with the latter expected to increase on higher auto sales and student loan growth. Minutes from the Federal Open Market Committee meeting in June will also be released and could prove to be interesting. On the day of the release, Fed Chairman Bernanke will give a speech in Boston after the market closes. Also, look for the Bank of Japan to say that it expects to maintain the current level of ultra-low interest rates in that country and for China to comment on its ability to achieve a soft landing.

Highlighting the earnings reports in the coming week are JP Morgan Chase and Wells Fargo, both of which are expected to report increased earnings and revenues. Their reports are likely to set the tone for the market as the financial sector’s performance is closely tied to the performance of the overall market. Investors should also be mindful of the three bond auctions this week. The Treasury is auctioning $32 billion in three-year notes, $21 billion of 10-year notes and $13 billion of 30-year bonds.   

Other notable companies scheduled to report second quarter results this week are Yum Brands (owner of Pizza Hut, KFC and Taco Bell), Family Dollar Stores and Commerce Bancshares. 

Portfolio Strategy

The markets are likely to remain volatile as earnings reports are digested and companies give their all-important guidance for the balance of the year. Expectations are relatively low for earnings as the economy remains sluggish and is unlikely to accelerate anytime soon. As important to the actual earnings themselves is how the market reacts to those earnings reports. Much of the good news in terms of corporate profit growth may already be reflected in stock prices. If companies temper their outlook for earnings growth going forward, the stock market may have seen their best gains for the year. Although we remain optimistic about the stock market on a long-term basis, the next several months may be bumpy.

The same volatility may also hold true for the bond market as it is difficult to determine how much of the Fed’s tapering program is already built into bond prices. The Fed has not given any specific timetable on when its stimulus program will be curtailed, yet the bond market seems to have it all figured out as it has sold off in anticipation of such a move. Low inflation, high unemployment and slow GDP growth all argue for still low interest rates, but the market senses that future data on these key economic indicators will lead to higher rates down the road. The market may indeed be ahead of itself, in which case current rates offer attractive investment opportunities for fixed income investors.