Oct. 6–The market is trading on tenterhooks. A little bit of bad news, and the Dow is down 100 points; a little bit of good news, and it’s up 200. It’s enough to make investors dizzy.
The next three weeks should prove just as volatile, as earnings season begins to shower the market with daily reports that companies have met, beaten or missed expectations.
“That’s going to be the key driver,” said Brett Gallagher, head of U.S. equities at Julius Baer Investment Management in New York.
Reports by Alcoa Inc. and PepsiCo Inc. on Tuesday and General Electric Co. on Friday help kick off things this week; the deluge will last the rest of the month.
“These companies are the first ones out of the gates, so the market has a tendency to overreact to them,” said Joe Cooper, an analyst at Thomson First Call, which compiles analysts’ earnings estimates.
Earnings across the board are expected to rise for the sixth straight quarter. For the broad Standard & Poor’s 500 index, First Call is forecasting earnings growth of nearly 16 percent for the third quarter. That compares with increases of 11.7 percent and 9.5 percent for the first and second quarters.
And that’s a conservative estimate, said Charles Hill, First Call’s research director. If all the companies expected to come in above expectations succeed in doing so, earnings growth could approach 20 percent. That would be the best showing in more than three years.
“No matter how you look at it, it’s going to be a good earnings season,” Mr. Hill said. “What analysts have increased their estimates by is about the same as what they have usually trimmed by now.”
At the start of the quarter, analysts were calling for earnings of S&P 500 companies to rise 13.5 percent. Today they are at 15.9 percent.
In most quarters, the opposite occurs. In other words, if this season had followed a normal pattern, growth estimates at this point would be 11 percent.
It’s these lofty expectations that could make the stock market all the more volatile, some experts say.
Mr. Gallagher calls today’s stock market “two-tiered.” There are stocks trading on what analysts call fundamentals and stocks trading on high hopes.
In an apparent return to the logic of the late 1990s, he said, the market this year has shunned companies with strong cash flow, profits and balance sheets call that the first tier.
In turn, it has rewarded companies that can hardly back up their stocks’ ascents with the same justifications call that the second tier.
“When you try to justify where some of these stocks are trading based on fundamentals, you just can’t do it,” Mr. Gallagher said.
John Waterman has seen the same trend. As chief investment officer at Nuveen’s Rittenhouse Asset Management Inc. in Philadelphia, which manages $12 billion in large-capitalization growth funds, Mr. Waterman has produced two studies of companies with market values of $5 billion or more.
Within that universe, the 10 largest household-name companies in the country are trading at 19 times next year’s earnings and are up, on average, a respectable 16 percent this year.
On the high-hopes end of the spectrum, the top 10 performers through Sept. 30, mostly in technology, are up an average of 126 percent and trade at a price-to-earnings ratio of 68 times next year’s earnings.
“When we see the top 10 performers as a group trading like this, we say either the price is too high, or earnings are too low,” Mr. Waterman said.
The market may encounter hiccups if or when some of these high fliers merely meet their expectations.
“The valuations are saying that they are going to beat their estimates,” Mr. Waterman added. “If they just meet them, they’re going to sell off.”
An ‘echo bubble?’ Between 1999 and March 2000, the 50 most volatile stocks in the S&P 500 outperformed the overall market by a factor of 2 to 1, according to a recent Merrill Lynch study. The 50 stocks in that category today once again have risen nearly twice what the market has in the latest rally.
The difference between then and now? By the companies’ own forecasts, their expected growth rates are much lower today.
“There’s this expectation that at some point we’re going to accelerate to where we once were, and I just don’t think that’s going to happen,” Mr. Hill said.
One thing Mr. Hill and Mr. Gallagher agree on is that there is no predicting when the party may end for some of this year’s biggest winners.
“There’s no question in my mind that we’re seeing a lot that’s reminiscent of the bubble era call this an echo bubble,” Mr.
Gallagher said. “But I don’t know if this earnings season is going to be the trigger.”
Helping stave off a correction, he said, is the phenomenon of portfolio managers stretching for good performance as the year winds down.
“There are a lot of fund managers out there trying to play catch-up, and it’s a bit of a scramble right now,” Mr.
Gallagher said of days like last Wednesday, when the market bolted upward by 200 points on seemingly benign news. “A lot of hedge fund managers don’t get paid unless they perform, and they are going to be a bit more schizophrenic than usual.”
Eventually, most agree that there will be a rotation out of the more speculative names and into more conservative stocks.
Aside from Intel Corp., Mr. Waterman said, the companies on his 10-largest list should be among those leading the charge.
“We call these companies high-quality because none of them are betting on a cyclical recovery,” he said. “They’ve tended to lag the market and are selling at good valuations. We’ll see this quarter if the leadership changes.”
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