T2W Trading Community

Bullish leg of earnings growth sprained?
One of the legs to the bullish case has been strong earnings growth. I don’t dispute this, nor do I think earnings will falter significantly in the short -term, but looking under the hood is instructive. Less than 10% of the S&P 500’s constituents have reported second-quarter earnings, but growth so far has remained strong, up 31% relative to last year’s results and 6% higher than analysts’ expectations, according to Thomson First Call.

However, the energy sector has been the big player in the earnings game over the past couple of years, and prospects for continued relative earnings outperformance are questionable. First, there’s the simple math of more difficult earnings growth comparisons on the horizon given the stellar results historically. Then, there’s the difficult relative first quarter the energy sector saw—falling short of its consensus earnings growth forecast by about 7%, the worst relative underperformance of all 10 Global Industry Classification Standard (GICS) sectors. (For comparison purposes, and remaining supportive of our underweight energy/overweight technology recommendation, the tech sector’s earnings growth exceeded consensus expectations by over 20%.)

Energy’s contribution to earnings tiring?
Here’s the full rundown of first-quarter relative earnings growth performance compared to initial expected growth:

Technology                          +22%
Materials                              +19%
Consumer discretionary   +11%
Industrials                            +10%
Financials                             +9%
Health care                           +7%
Consumer staples              +4%
Utilities                                  -2%
Telecom                                -7%
Energy                                   -7%

Source: Thomson Financial

If this is a new trend developing, where earnings growth rates for the hottest sectors (energy and telecom) are underperforming expectations, we would expect a greater deceleration of overall S&P 500 earnings growth than is currently baked into the market cake.

Nasdaq under major pressure
Clearly not (yet) being helped by strong technology earnings results, the Nasdaq has gotten particularly bludgeoned of late. I turned to MarketHistory.com for some historical tendencies around this latest action. The Nasdaq closed last week with a 4.4% decline, trading at a 13-week low, and came within two points of trading below the lowest low over the past 52 weeks. What does history say about such weakness in the month of July?

Question: How has the Nasdaq performed in the past when it has lost more than 3.0% over the course of a week in July?

Answer: The index saw this event on 15 prior occasions since 1971. The Nasdaq continued to decline over the next six trading days in 13 of the 15 cases (87%) by an average of -3.5%. The average of the two rallies was +2.7%. The overall average return of all 15 cases was -2.7%.

So?
The technical picture is clearly ugly, as is the global rate picture. Earnings growth remains healthy, but is coming under increasing pressure. The consumer is already under massive pressure with interest rates up and oil prices nearing $80 a barrel, and the bull market’s long in the tooth. There’s a race being fought currently, between rising inflation in the near term and faltering economic growth in the longer term. These races have been run before, typically causing financial accidents and a bit of market pain. The inverted yield curve heralds a potential recession. Throw more turmoil in the Middle East into the mix, and you have a recipe for continued market volatility. Cash is your friend.