Earnings Arrive At Crucial Juncture

1/21/2013


Stocks enter the heart of earnings season with expectations for December-quarter results fairly modest, sentiment increasingly bullish, the Dow Transports at all-time highs, and the Dow Industrials near significant highs. A close in the Industrials above 13,610.15 would reconfirm the bullish primary trend under the Dow Theory. For now, our Buy List and Focus List have 93.8% in equities, versus 89% for our Long-Term Buy List.

Surprise, surprise

Expectations for December-quarter earnings have been cut dramatically in recent months, partly because of a worse-than-usual preponderance of profit warnings. Consensus estimates now project 1.9% year-to-year growth in per-share earnings for the S&P 500 Index, down from the 9.9% growth projected on Oct. 1, according to Thomson Reuters.

Expectations for nine of the S&P 500's 10 sectors have been cut since Oct. 1, with only the utility sector seeing improvement. S&P 500 Index earnings are expected to decline from the September quarter, a reversal of the typical seasonal pattern.

Bulls argue that low expectations have set the table for an upside surprise and a market rally. We are keeping an open mind, for several reasons:

• First, companies have learned to guide analysts' estimates low enough that they can be exceeded, and many investors now view earnings that match the consensus as disappointing. Since the beginning of 2010, the average underestimation for S&P 500 Index earnings has been 3.5%. Assuming a similar "surprise" this quarter would put S&P 500 earnings growth at 5.4%.

• Second, the consensus still projects 10.6% growth for S&P 500 Index profits in 2013, down only slightly from the 11.6% expected on Oct. 1. While few may truly expect double-digit growth, it is hard to know exactly where expectations stand. The 2013 guidance provided with December-quarter results — and the market's reaction — will be crucial.

• Third, sentiment has become increasingly bullish, with surveys of newsletters, fund managers, and individual investors revealing a jump in stock-market optimism. If December-quarter results or 2013 guidance prove even modestly disappointing, a market dip would not be surprising.

Conclusion

Historically, investors have done well owning stocks when both the Industrials and Transports are reaching significant highs. A close above 13,610.15 in the Industrials would put both averages at significant highs — and reconfirm the bullish primary trend. Magna International ($52; MGA) is a timely pick.


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