Over the past few weeks we have received multiple earnings announcements from major companies across many sectors of the economy that have been disappointing. Many have missed analyst projections and some have missed management guidance, resulting is sharp declines for these stocks. Coupled with the technical weakness that has developed within the major indexes, these earnings misses serve to cast doubt on the longevity of the current stock market rally.
The stock market has enjoyed a strong rally from the bottom of the last correction, which formed in late May/early June at around 1,266 on the S&P 500. From that low, stocks have rallied to as high as 1,474 (Sept. 14, 2012), or by 16.4 percent.
From that recent high, however, stocks have slowly retreated, accelerating the decline on Friday with a 24-point drop on the S&P 500 (1.66 percent), a 205-point drop on the Dow (1.5 percent) and a 67-point drop on the NASDAQ (2.2 percent).
With a close of 1,433 on the S&P 500, we have retraced about 2.8 percent from the recent high. Some in the media, especially after Friday’s drop, have recommended buying, their “logic” being that with the overall drop in stocks, and more significant falls in the likes of Apple, Google and others, that this is a buying opportunity in an ongoing bull market rally. I disagree.
Google was perhaps the most significant earnings miss for the third quarter. The company not only missed on both the top line and the bottom line (revenues and earnings missed analysts’ estimates), but it mistakenly released its report early, shocking the markets and driving Google’s share price down more than 8 percent on Thursday.
Some of the other notable misses were General Electric, which showed an 8.3 percent profit rise but missed on the top line; Honeywell, which also had good earnings but missed its revenue expectations; Microsoft, which missed both top and bottom line estimates; AMD, which had an earnings miss and announced that it will lay off 15 percent of its workforce; American Express missed on the revenue line; IBM, which beat on the earnings line but missed revenue estimates; and Coca-Cola, which met earnings estimates but missed on the revenue line.
From a technical analysis perspective, we have at least two major problems for the markets. First, the Dow Transportation index has diverged from the Dow Industrial index. Dow theory states, in part, that if this occurs, the Transports drive the bus. In other words, if the Dow Industrials are going up and the Dow Transports are going down (as is the case right now), the Transports will pull the Industrials down. As can be seen in the chart below, in mid-July, the Dow Transports began to diverge from the Dow Industrials and have widened the gap since.
Second, the NASDAQ, which is heavily technology weighted, is diverging from the Dow Industrials. During a time of economic expansion, which is where we find ourselves today (albeit a very slow expansion), technology companies tend to have stronger earnings than the companies across the broader economy. As a result, the NASDAQ, with its high-growth technology emphasis, should lead the market higher during rallies. Recently, the NASDAQ Composite index has begun to move lower, again diverging from the Dow Industrials. This is another clear indicator of a correction to come.
In the chart above, we can see that the Dow (.DJI) continued to advance or maintain its level, which the NASDAQ (.IXIC) clearly rolled over and headed down from the peak in mid-September.
Will Friday’s sharp declines continue this week? That is anyone’s guess. There will certainly be those who see this recent dip as a buying opportunity. Volatility is sure to continue to be extreme, and I would expect, as a result, to see stocks bouncing around. However, from what I see, if we recognize the importance of disappointing earnings coming from major companies across multiple sectors of the economy, the technical deterioration of the major indices, the pending election, the fiscal cliff —Bush-era tax cuts and spending cuts set to go into effect at the end of this year, weakening GDO growth, and the troubles in Europe — to me, it is unlikely that stocks will continuing to rally significantly from current levels.
It makes much more sense that all of these factors will eventually pressure stocks, with investors processing this information over the coming weeks and months, and ultimately concluding that stocks are too expensive to sustain current levels. Many investors have substantial paper profits accumulated, and should be motivated to lock in these profits before the market sells off.
I expect to see at least a 15 percent correction from current levels, and further expect to see the S&P 500 fall to 1,250 or lower between now and the end of the year. It would not surprise me to see 1,200 or lower. Those who take action now to sell positions and raise cash should be in the best position to reinvest at much lower levels, once the correction takes place.