Weak earnings will not tame bulls

New York: Despite a mediocre earnings season and signs of an overbought market, Wall Street bulls are likely to remain in control this week.

So far in this earnings season, 352 companies in the S&P 500 have reported results, of which only 63 per cent have beaten Wall Street estimates. This compares to a beat rate of about 70 per cent on average for the past four quarters and would be the lowest since the fourth quarter of 2008.

Usually, strong earnings are associated with stock market rallies and improved investor sentiment. But despite this season's relatively weak results, the S&P is up nearly 7 per cent for the year, and the index has posted gains for every single week in 2012 except for a 0.2 per cent loss last week.

"The demand for risky assets is strong. There is steady buying in the market, and the money is constantly being put to work," said Brian Lazorishak, portfolio manager at Chase Investment Counsel in Charlottesville, Virginia.

"The market is sort of overlooking the weak 2011 earnings and looking forward to an improved 2012 earnings season... It's like a green light to investors to get into risky assets."

There are a number of catalysts that have helped the market this year, including a slew of improved economic data and the Federal Reserve's vow to keep interest rates low.

Earlier last week, Fed Chairman Ben Bernanke reiterated his plans to hold interest rates at record lows until late 2014. Many economists were looking to see if Bernanke might waver on that stance after last week's news that hiring surged in January and the unemployment rate fell to a three-year low of 8.3 per cent.

Also last week, the Institute for Supply Management said its services index rose in January to its highest since February 2011.

"Earnings upgrades by sell-side analysts tend to move in line with economic momentum, with global earnings momentum typically turning positive when the ISM new orders moves above 52," said Credit Suisse Group AG's analyst Andrew Garthwaite.

New orders

"Yet, new orders are now at 57, and earnings momentum continues to be clearly negative," he said, adding that "this was a problem but not necessarily bearish for markets."

The S&P 500 fell 0.7 per cent on Friday, its biggest percentage decline so far in 2012 after an about-face on Greece's long-awaited debt deal ended a five-week streak of gains for equities.

This week 51 S&P 500 companies are expected to report earnings. The earnings growth rate for the S&P 500 for the fourth quarter of 2011 is now at 8.9 per cent, according to Thomson Reuters I/B/E/S. However, excluding Apple, the overall growth rate is at 5.8 per cent, the research report said. Companies expected to report this week include MetLife and Goodyear.

Despite the optimism in the stock market, options traders are bracing for more volatility ahead.

Wall Street's favourite pulse of investor sentiment, the CBOE Volatility Index, or VIX, jumped nearly 12 per cent to 20.79 after peaking at 21.98 on Friday. The VIX, a 30-day risk forecast of expected stock market volatility conveyed by S&P 500 option prices, typically moves higher when stocks decline.

"The sharp move up in the VIX, especially over the last hour, suggests that there is serious concern over the European debt crisis and traders are looking to options to protect their equity positions heading into the weekend," said optionMonster analyst Chris McKhann.

"If these volatility buyers are correct, then Monday could be ugly for equities."

Typically the options risk gauge is relatively weak on a Friday as traders factor in time decay in the price of the SPX options. But the daily percentage move was huge on Friday. The VIX logged its biggest daily percentage gain in three months, given that the S&P is down by less than 1 per cent.

VIX futures also made very large moves to the upside. The February futures, which have only two days of trading left, jumped 12.5 per cent at 22.50. The contract closed at 21.75.

Shares also advanced in the TVIX, the VelocityShares Daily 2X VIX short-term exchange-traded note, which is designed to gain or lose at twice the rate of the underlying index on a daily basis.

The leveraged ETN, based on the front two-month VIX futures, gained 17.14 per cent to $19.07, and is now more than 50 per cent in value over the past four sessions.

"This suggests that traders are paying up to buy volatility as a hedge against a continued decline," McKhann said.

Economic indicators due this week include retail sales on Tuesday and industrial production on Wednesday. On Thursday, housing starts, jobless claims and the producer price index are due. The consumer price index will be released on Friday.