Monday Morning Outlook: Earnings Season Kicks Off With a Whimper
Traders appear to set a high bar for earnings
by Todd Salamone 1/16/2010 11:13 AM
Expiration week -- which historically has a positive bias -- fell to the bears on Friday. The pullback was especially notable due to the fact that the S&P 500 Index (SPX) was rejected at the 1,150 level, an area that is being closely watched by technical analysts. Last week also kicked off the start of fourth-quarter earnings season, but Alcoa Inc. (AA) forgot to bring the party supplies. The Dow Jones Industrial Average (DJIA) followed the blue chip's lead, and headed lower on the week. Looking ahead to next week, Todd Salamone, Schaeffer's Senior Vice President of Research, analyzes the volatile start to the fourth-quarter earnings season, and considers some long-term technical indicators. Next, Senior Quantitative Analyst Rocky White takes a closer look at the negative reaction to Alcoa's earnings miss, and examines the potential impact on the market as a whole. Finally, we wrap up with a look at some key economic and earnings reports slated for release this week.
Recap of the Previous Week: Alcoa, China, and JPMorgan Rain on Bulls' Parade
By Joseph Hargett, Senior Equities Analyst
With the start of the fourth-quarter earnings season scheduled for after the close of trading, Monday's session proved to be uneventful. The major market indexes rose to a fresh round of 52-week highs, and then treaded water for the rest of the day. On the economic front, two Federal Reserve members took the opportunity to reiterate the Fed's stance that interest rates will remain low for "quite some time." Against this backdrop, the Dow Jones Industrial Average (DJIA) started the week with a gain of 0.43%.
But then Alcoa Inc. (AA) rained on the parade, posting a weaker-than-expected profit of a penny per share. Wall Street interpreted the blue chip's disappointing results as an ominous sign for the remainder of the corporate earnings season. Adding to the bearish tone of the session was news that China's central bank moved to tighten monetary policy to help curb the country's fast-growing economy. That development sparked concerns about China's role in the global economic turnaround, and contributed to the end of the Dow's six-session winning streak, with the venerable average shedding 0.34%.
Stocks recovered quickly on Wednesday, with the Dow resuming its quest for new annual highs. Wall Street's most powerful CEOs, including Lloyd Blankfein of Goldman Sachs (GS) and Jamie Dimon of JPMorgan Chase (JPM), were grilled before Congress about their roles in the financial disaster. Under tough questioning, they conceded that regulatory reform is necessary. The Dow responded by rallying 0.5% on the session.
Encouraging data on the business front and a tech-sector rally ahead of Intel Corp.'s (INTC) trip to the earnings confessional extended the Dow's rally by 0.28% on Thursday. Bulls cheered the government's announcement that business inventories increased by twice as much as expected in November, while largely overlooking a steeper-than-expected jump in first-time jobless claims and an unexpected 0.3% decline in December retail sales.
JPMorgan's Dimon was back in the spotlight Friday morning. Although JPM handily exceeded analysts' consensus earnings estimates, traders focused instead on the bank's revenue miss -- as well as Dimon's gloomy outlook. Dimon bluntly admitted, "We don't know when the recovery is." With a consumer sentiment report also coming in weaker than expected, the Dow responded by plunging 101 points, or 0.94%, its largest point drop of the year. For the week, the Dow dropped 0.1%. The other major indexes fared even worse on the week, with the S&P 500 Index shedding 0.8%, while the Nasdaq Composite fell 1.3%.
What the Trader Is Expecting in the Coming Week: Short-Term Risks Remain Intact
By Todd Salamone, Senior Vice President of Research
"Clearly, the sentiment backdrop among retail investors and retail equity option buyers is more reflective of that heading into October 2009's earnings season than July 2009 earnings season. In other words, there is currently not quite the fear that existed ahead of the July 2009 earnings releases. In October, stocks experienced a mild correction as the first earnings reports began flowing... Will the upcoming earnings catalyst reverse the New Year's cheer? Will we see a repeat of October's 5% decline? Bulls should certainly be open to this scenario and consider hedging long positions in the event that January 2010 is indeed a repeat of October 2009."
Monday Morning Outlook, Jan. 9, 2010
Last week, I compared and contrasted the market's sentiment backdrop now relative to the sentiment backdrops in July and October 2009. Pessimism preceded a rally in response to earnings reports in July; trader optimism preceded a decline in response to earnings reports in October.
The good news is that during the first week of earnings season, the S&P 500 Index (SPX) hit its highest levels since October 2008. But the bad news was the market's negative reaction to key earnings reports, specifically Alcoa (AA), Intel (INTC), and JPMorgan (JPM), during the course of the week. Friday was especially painful for the bulls, as the SPX lost 1.08% after trading higher in eight of the first nine days of the year. Friday's close was right around the close of Jan. 5. Welcome to the world of mean-reversion!
Last week marked the official beginning of earnings season. The short-term, earnings-related risks that we highlighted last week remain intact. We are still seeing evidence of short-term optimism among traders, which creates the "buy the rumor, sell the news" scenarios that we saw with respect to the AA, INTC and JPM reports.
One example of the enthusiasm that we are seeing among short-term traders is evident in the activity of retail equity option players. The chart below displays the 10-day average of the customer-only, equity-only buy (to open) call/put ratio on the International Securities Exchange (ISE), with an SPX overlay. The higher the ratio, the more enthusiasm there is among equity option players. It is pretty clear that we are at an extreme, and at levels that have preceded hiccups in the market within the context of its advance since the March 2009 low.
Next week also marks the beginning of a five-week cycle between January and February option expirations. Our research indicates that, per the table below, since 2006 the first week of a five-week expiration cycle performs poorly compared to the expected returns in a typical week and to the first week of expiration in a four-week cycle. Our theory is that portfolio managers replace expired portfolio insurance in the post-expiration week. Those selling the index puts hedge by shorting futures, which typically creates a tailwind for the market.
From a technical perspective, long-term resistance levels on the broader indexes could cap short-term rally attempts. For example, we have previously noted the SPX's next major hurdle –the 160-month moving average – which is situated just overhead. This trendline marked the 2002-2003 lows, and a move below this moving average in October 2008 signaled five months of painful selling. This long-term moving average is currently situated at 1,157.70, and last week's high was 1,150.41. Coincidentally, the 1,150 area has historical significance as well, as it marked resistance for a six-month period just ahead of the final leg down in the 2000-2002 bear market. Additionally, the 1,150 area acted as resistance from February through October 2004, and as a major area of support in April 2005. We see support for the SPX in the 1,100-1,120 area, and resistance in the 1,150-1,160 area.
Similarly, the Russell 2000 Index (RUT) could be challenged by former support and resistance areas. Per the chart below, the RUT's 80-month moving average is situated at 645.10, a trendline that provided support during the October 1998 and September 2001 declines. Breaks of this trendline in July 2002 and October 2008 signaled poor market environments for the bulls in the following months. The RUT is knocking on the door of its 80-month moving average for the first time since October 2008. In fact, last week's highs were in the 645 area. Also worth noting is the 650 area, which acted as resistance in December 2004 through June 2005 and support from January through September 2008. We see support in the 620 area on the RUT, and resistance in the 650 area.
As Bernie Schaeffer noted in a commentary on Jan. 7, 2010, a monthly SPX close above its 160-month trendline would "be a very important next step in re-establishing whether or not the market is in bull mode." For now, our advice from last week has not changed. That is, consider protective puts on your long positions as we move through the potentially volatile earnings season.
Prepare for the investing week ahead. Every week, Bernie Schaeffer and his staff provide you with their insight about what has happened and, more importantly, what will happen in the market. We dig deep and show you what's happening behind the scenes, and tell you which indicators are predicting major market moves. If you enjoyed this week's edition of Monday Morning Outlook, sign up here for free weekly delivery straight to your inbox.
Indicator of the Week: Is Alcoa an Indicator?
By Rocky White, Senior Quantitative Analyst
Foreword: Each earnings season, Alcoa Inc. (AA) is one of the first major companies to report. Last week, after the close on Monday, AA reported a profit of a penny per share. The company was expected to show a profit of about 5 cents per share, resulting in a disappointment to many investors. Consequently, AA fell by 11% the following trading day. The analysis below shows that the giant aluminum company historically has been a pretty good indicator of what's to come for the market. However, industry developments and company-specific details in the earnings release might cast doubt on this indicator's validity this quarter.
Past Five Years: The following tables show data for the S&P 500 Index (SPX) returns following Alcoa earnings reports for the past five years. The table on the left shows data for the two weeks following the report, while the table on the right looks at returns for the three months following a report - approximately the amount of time between quarterly reports. I broke down the returns depending on whether AA was up the day of the earnings reaction (positive reaction) or down (negative reaction).
SPX returns following Alcoa earnings reactions
Whether you are looking at returns for 10 days or three months after a report, the market has followed Alcoa's post-earnings direction. Focusing on the three-month data, the SPX is up 67% of the time, with an average gain of 2.84%, when investors buy AA following the company's earnings report. However, when AA reacts negatively to the release, the market loses 1.32% on average during the next three months, and is positive less than half the time.
Finally, I included a table highlighting AA's earnings reaction following the company's prior 20 reports, as well as the SPX's subsequent returns (green rows indicate a positive earnings reaction). Note that the last negative reaction was in July 2009. Despite that, the market soared higher, gaining almost 20% during the next three months. Before that, the previous five negative reactions presaged negative market returns for the next three months.
Implications: The analysis above shows the reaction to Alcoa's earnings report has been a pretty good predictor for the market going forward. However, as I mentioned at the onset of this analysis, there was some news this week that hit AA's sector especially hard. Specifically, China announced that it was tightening banks' reserve requirements, which could slow growth and demand from that region. Additionally, Alcoa faced questions regarding a very high amount of trading volume that it conducted for zero profit, which caused AA to miss its earnings target by a wide margin. These two factors could give less significance to the implications of the recent negative reaction for the rest of the general market. |
