Business News

Can this rally continue?

| More

by Peter Switzer

Last week Wall Street stormed home with a solid rise of the market indexes following better-than-expected earnings reports but this is just early days for the US reporting season. And with the employment story still disappointing, the report card of major American companies will make or break this current rally.

In case you missed it, the Dow was up 0.96 per cent for the week to 11,787.38, the Nasdaq put on 1.93 per cent to 2755.3 and the S&P 500 rose 1.71 per cent to close at 1293.24.

Strong rally

That was a good week for shares after the Yanks already enjoyed a Santa Claus rally to close the year. Over December, the S&P 500 index went up around 6.5 per cent and so there’s certainly a new commitment to stocks in the States.

It coincides with the fear index or VIX now at 15.4, which is a low number associated with less anxiety about future gyrations in share prices.

This rally is a strong one with the technical analysis showing the S&P 500 has not cut below its 10-day moving average for 30 days in a row. In fact, the index is up 22 per cent since last August and anything from left field could turn this rally around.

Makers and breakers

So could earnings be the maker or breaker of this rally? Of course, there is Europe, US foreclosures, even debt problems for state and municipal governments but let’s focus on earnings.

Last week’s JPMorgan Chase result showed there was scope to increase its dividend and this got many excited that US banks were turning the corner.

Meanwhile, Intel also reported favourably, suggesting that this earnings season should be good but The New York Times found reason to pour cold water on this optimistic conclusion.

Threat to the rally

Paul Lim from the newspaper says despite positive sentiment and good news on the corporate earnings front, a fall in price/earnings numbers could spoil the rally!

This fall in P/E is happening just when the American Association of Individual Investors say most investors now want to hold shares again but Lim has another argument.

He points to the Standard & Poor’s P/E for the S&P 500 index, based on 2011 estimated operating earnings, which is now 13.3. This is down from the 15.1 at this time last year, based on 2010 estimated profits.

Earnings continue to rise but at a slower pace and this will be watched closely by number crunchers.

Market clichés

History shows as earnings slow to a lower growth rate, P/Es also slip or slump, depending on the pace of the slowdown.

While the momentum is with the market now, by mid-year there could be a market reaction to any significant growth of earnings slowdown. And don’t forget that US market cliché, which worked out last year: “Sell in May and go away.”

Lim also looks at a potential inflation threat as this can also hurt P/Es. However, inflation would have to get over three per cent to threaten P/Es and I can’t see that happening in the US this year.

Earnings watch

The New York Times article in fact made me less concerned about inflation pointing out that “since 1871, the market’s P/E has hovered between 17 and 18, on average, in periods when inflation has grown at an annual rate of one to three percent. That’s well above the current P/E of about 13.”

While inflation is something that doesn’t bother me at least to mid-year, I will be watching earnings closely this week. Of course, the size of the US rally since August means a sell-off is to be expected but if the earnings remain solid, then it will be a buying opportunity.

Important information:This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.

The Switzer Super Report is a newsletter and website for self managed super funds. With exclusive commentary from Peter Switzer and Paul Rickard the Switzer Super Report will help you maximise your after tax investment returns and grow your DIY Super. Click here for a free trial or subscribe today.

Published on: Monday, January 17, 2011