Bulls Unshaken as Profit Duds Rattle US Stocks in Winding Week

New York (Oct 16)  A gloomy beginning to earnings season sent U.S. stocks to a second week of losses. A trio of Wall Street’s biggest bulls say don’t worry.

It was a week of twists as the S&P 500 Index alternated between gains and losses, a rarity during the bull market but one that’s now happened four times this year as sentiment is swinging on everything from central-bank policy to the U.S. election and perceptions on the economy’s strength. Earnings took a turn in the spotlight in the latest week, as a profit miss from Alcoa Inc. rattled the market before signs of life from the largest banks buoyed optimism.

For Thomas Lee of Fundstrat Global Advisors, the latest gyrations are just turbulence on a ride that will leave the market higher by 9 percent come 2017. RBC Capital Markets LLC’s Jonathan Golub and Bank of Montreal’s Brian Belski, with Lee among the bull market’s biggest cheerleaders, say the rocky start to earnings matters little. They’re declaring the longest profit recession since the financial crisis over, clearing the path for equities to rally into the new year.

“While we are disappointed in the weak equity market performance month to date, we still see stocks strengthening through 3Q16 results and ultimately seeing equities rise into year-end,” Lee wrote in a note to clients Friday.

The S&P 500 ended the five days lower by 1 percent at 2,132.98, while the Dow Jones Industrial Average dropped 102.11 points, or 0.6 percent, to 18,138.38.

The reporting season started with a thud, as the S&P 500 tumbled the most in four weeks on Tuesday after Alcoa’s profit miss and companies including Illumina Inc. warned of disappointing results. JPMorgan Chase & Co. and Citigroup Inc. helped the benchmark eke out a gain on Friday as results topped forecasts.

“For the week, the markets got queasy because of Alcoa and that set the tone,” said Diane Jaffe,  group managing director at TCW Group, which oversees $195 billion. “But big money banks have reported, and things are looking better. All of a sudden, everyone’s valuation work looks attractive because earnings are growing.”

A rebound in corporate profits would help check valuations that by some measures indicate stocks are near the most expensive in two decades. The current price-earnings ratio for S&P 500 stocks is 19 percent higher than the 10-year average, data compiled by Bloomberg show.

“Deteriorating levels of earnings growth had been a major thorn in the market’s side over the past year,” Belski, who estimates S&P 500 profits rose by 15 percent last quarter, wrote in a note to clients Friday. “However, the environment is set to change in a big way for the 3Q reporting period.”

When S&P 500 profit grows by 10 percent or more in a quarter, the index gains an average of 2.7 percent for the calendar quarter, according to BMO data. A jump the size Belski predicts could enable the S&P 500 to reach his year-end target of 2,250, a level 5.5 percent above Friday’s close. The average forecast among 19 strategists surveyed by Bloomberg is 2,171, implying a gain of just 1.8 percent through the end of the year.

To Golub, valuations don’t have to fall for stocks to power to his year-end target of 2,225. He says price-earnings ratios can rise further, listing companies’ ability to turn profits into cash flow among the reasons.

“With multiples well within a normal band, the current swing higher appears far from over,” he wrote in a note to clients Thursday.

While the group of strategists is persistently bullish -- they’ve called for gains in the equity market 82 percent of the time during the past decade -- history shows that breaks in earnings slumps that have reached five quarters usually precede some of the stock market’s strongest periods. Analysts in a Bloomberg survey predict net income fell by 1.4 percent last quarter, though the expected rate of decline is so small that it will almost certainly evolve into a gain when companies are done beating estimates.

An end to the profit recession would also stabilize a market preoccupied with the path and timing of Federal Reserve interest rate increases. Rising odds for a December hike have pushed U.S. stocks lower amid data showing steady but slow growth. Companies whose fortunes are more closely tied to the economy fared worst in the week, with health-care stocks and raw-material producers leading declines.

Source: Bloomberg