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It's the Earnings, Stupid.

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Friday, August 16, 2013

(Note: Mark Vickery will hold the fort  in my absence next week)

The consensus narrative for the market’s loss of momentum puts the blame on renewed Taper fears. This would make sense only if one started with the assumption that the market wasn’t pricing in some sort of Taper action later this year all along. But unless Mr. stock market was out vacationing on a remote island the last few months, it is hard to imagine anyone not confronting the Taper question one way or the other.

My sense is that it isn’t renewed Taper fears, but rather a realistic assessment of ground realities that is prompting investors to get cautious. The most important of these reality checks is the ‘iffy’ earnings outlook emerging from the Q2 earnings season. The market’s strong gains thus far needed to be confirmed by momentum on the earnings front. But we are witnessing is the opposite of what should be happening at this stage

Does the corporate earnings picture emerging from the Q2 earnings season justify a market making fresh al-time highs day after day? It may sound like a rhetorical question, but it actually isn’t.

Estimates for Q3 have been falling like a rock as the Q2 reporting season has moved towards the finish line. But consensus expectations still reflect double-digit growth rates in Q4 and 2014. Given what we have heard just in the last couple of days from the likes of Cisco ((CSCO - Free Report) ), Wal-Mart ((WMT - Free Report) ), Macy’s ((M - Free Report) ), Nordstrom ((JWN - Free Report) ) and many others before them, it is time to scale back those Q4 and 2014 expectations. The market has seen what has happened to Q3 estimates and can easily foresee what is in store for estimates for the outer quarters.

It is hardly surprising that investors are skittish as they lose confidence in current consensus earnings estimates, particularly in a backdrop of rising treasury yields. Yields are still low by historical standards, but I give no credence to the claims that the jump in 10-year yields from roughly 1.6% in May to the current roughly 2.8% should have no stock market impact. This morning’s good enough Housing Starts and Permits data shows that the housing Recovery has been able to sustain itself despite the rising rates. But it probably doesn’t make sense to assume that rising interest rates will have no impact whatsoever on the sector.

Market optimists continue to hold out hopes for earnings growth ramp up towards the end of the year and next year - that's why estimates for Q4 and next year still reflect double-digit growth rates. They can justifiably point towards the improving macro backdrop like Thursday’s sharp drop in Jobless Claims data, and even some tell-tale signs of green shoots in Europe. But if we don’t see any evidence of positive earnings momentum, as has been the case thus far, then the bulls would need to come up with a more plausible justification for the market’s record level.

With the Fed getting ready to get out of the QE business, irrespective of whether the Taper comes next month or later this year, stocks need earnings power to justify recent lofty levels. We haven’t seen that thus far. In fact, management guidance on the Q2 earnings calls, not just from Wal-Mart and Macy’s, but across the board from many companies in different sectors, are pointing towards an earnings picture that is significantly weaker than what investors are hoping for.

Sheraz Mian
Director of Research


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