Friday, August 3, 2012

The Rally Continues

Although roughly 70% of the companies in the S&P 500 have beaten earnings expectations for the second quarter, only 30% of those reporting have beaten revenue expectations - the lowest level since 2008.

This trend would confirm the general impression that economic activity remains tepid, and earnings gains have largely been achieved through efficiencies and cost cutting.  So it would appear logical that the stock market would also be mired in the doldrums.

However, that's not the case: the S&P has produced a total return of more than 11% through the end of July.

So what's going on here?

Yesterday's Financial Times provided a prospective:

But a closer inspection of the recent S&P rally shows investors are piling into defensive sectors, rather than growth stocks, and shunning volatile ones.

"The stocks that are driving the S&P 500 forward are those that have bond-like characteristics, " says Barry Knapp, US equity strategist at Barclays.  "This rally is a lot more about central bank policy than it is about market fundamentals."

A glance at performance data provided by Merrill Lynch confirms the general impression that the stocks providing above-average dividend yields have produced the strongest performance so far this year.

Telecommunication stocks - whose fundamentals, in my opinion, are shaky - have been the strong performers this year, rising almost +24% so far in 2012.  The fact that Verizon and AT&T pay dividend yields north of 4.5% has clearly been the catalyst for the group.

Even utility stocks - which suffered during the first quarter this year - have rebounded smartly.  Prices of stocks in the utility sector have risen by more than 9% in the last 6 months despite only average fundamentals.

Whether the market's rally will broaden later this year is one of the key question on investors' minds right now.

JP Morgan's Thomas Lee thinks the data supports a more bullish view. He points to the fact that the corporate credit markets are indicating a more optimistic view of the economy than the stock market:

Equity markets weakened over the past few days, in part reflecting disappointment over central bank action (Fed and ECB) and in part due to profit-taking. While it is intuitively hard to accept, it appears that economic momentum is actually improving (at least vs. expectations)....
Bottom line, we would recommend investors be buyers of the dip for reasons discussed above. Recall that investors are in record defensive/non-risky positions and, given the continued rally in HY and investment grade markets, all support a market that is poised for a melt up into year-end. We still see the S&P 500 reaching 1430 by year-end.

As yesterday's post suggested, Mr. Lee's views are definitely the minority on the Street, which is more bearish than it has been any time over the last 27 years.

Widespread negative sentiment, and reasonable earnings growth, would historically lead to further market gains.