WILL Q3 EARNINGS SUPPORT THE RALLY? Oct. 16, 2009

Being Street Smart

Sy Harding

WILL Q3 EARNINGS SUPPORT THE RALLY? Oct. 16, 2009.

The rally off the March low has been remarkable. The market plunged too far to its March low, on fears about the economy that had not been seen since the Great Depression. So a substantial rally off that low was to be expected.

Even so the rally has been unusual. A number of long-time successful money-managers have been warning since May and June that the rally was getting ahead of reality, factoring into stock prices a faster and larger economic recovery than will be experienced. Their evidence included that consumer spending, which accounts for 70% of the economy, cannot increase enough to make a difference for some time to come, citing consumer debt levels, high unemployment, increasing loan defaults and home foreclosures, etc., and that the banking industry still has problems ahead from rising home foreclosures and defaulting commercial loans.

Global hedge fund manager George Soros says “International economies will have some limited growth but the U.S. economy is going to be a drag on that global growth.” In April he said U.S. banks are “basically insolvent”, and apparently has not changed his mind, referring in remarks this week to the “bankrupt U.S. banking system”.

The Federal Reserve is no better than lukewarm on its hopes for economic recovery, expecting to have to keep interest rates low well into next year. Meanwhile, the Administration and Treasury Department are so concerned about the sustainability of the recovery that they are reportedly preparing yet another stimulus package.

However, there is nothing lukewarm about the confidence in the economic recovery being demonstrated in the market, its rally still barreling along at a blistering pace.

In June, in apparent agreement that the rally had gotten ahead of reality, the market began to roll over into a correction, and was down four straight weeks.

But the decline reversed on a dime in mid-July when 2nd quarter financial reports began coming in. The upside reversal actually began when respected bank analyst Meredith Whitney upgraded Goldman Sachs from neutral to buy the day before the bank issued its report. That started the ball rolling.

Then, although most companies, including most of the major banks, reported continuing revenue and earnings declines, they were touted as positive signs of economic recovery if the declines were not as bad as Wall Street expected.

That assessment (that earnings were positive because they were coming in “better than expectations”) gave the rally substantial new legs, even as the warnings of a slow recovery, perhaps even an economic relapse, began to be substantiated when economic reports began to turn sour again. Home sales, and retail sales declined again after several months of improvement in the summer. Job losses rose again after several months of “less worse” job losses. And consumer confidence began declining again.

But the market remained focused on earnings and hopes for earnings. After the 2nd quarter earnings reporting period ended, the market began to anticipate the improvement in earnings Wall Street promised would show up in 3rd quarter reports. Wall Street was even optimistic enough to say it would no longer be enough for sales and earnings to be “less worse”, or for earnings improvements to be due to cost-cutting and lay-offs. If the positive economic outlook was to be sustained, rising revenues would have to show up in 3rd quarter reports as the reason for improved earnings.

The third quarter earnings reporting period has begun, and so far, unlike the beginning of the 2nd quarter earnings reports, it’s been a mixed picture.

Bank analyst Meredith Whitney even reversed her outlook for the banking sector, moving Goldman Sachs back down to neutral from the buy upgrade that halted the July correction three months ago.

The market began this reporting period by rallying strongly in response to Alcoa’s report that its earnings were 71% below the 3rd quarter of last year, but that at least it had a small profit.

It also surged up in a big rally on Wednesday in reaction to Intel’s report that its sales and earnings declined again (but beat Wall Street’s estimates).

However, the market did not take kindly to Thursday and Friday’s reports from CitiGroup, J.P. Morgan, Bank of America (a $2.2 billion loss), nor from the likes of economic bellwethers General Electric (a 44% decline in earnings), IBM (lower sales), or chip-maker Advanced MicroDevices (another loss), or Halliburton ( a 61% earnings decline), even though most beat Wall Street’s estimates.

Those latter reactions could be signs the market may not be as willing to take “less worse” as a sign of economic recovery this time around. If so, that raises questions about where the market will get its support to extend the rally still further, particularly given its unusual longevity already, and the seemingly overbought condition created by that lack of a normal correction.

It’s still early in the earnings reporting period, and the market’s response to earnings reports the last couple of days may have been a temporary aberration.

But it may also be a warning that in its current over-extended condition the market is susceptible to a downturn if subjected to less than stellar earnings reports this time around.

Sy Harding is president of Asset Management Research Corp, publishers of the financial website www.StreetSmartReport.com, and the free daily market blog, www.syhardingblog.com.