Why the rally will end in 2 weeks

Favorable year-over-year reports will encourage the bulls . . . but after first-quarter earnings reports, reality will set in.

By Louis Navellier Apr 7, 2010 6:55AM
earnings stock picksOn Friday, we learned that the U.S. economy added 162,000 jobs in March -- the most in three years.

Investors everywhere are waiting for the Dow to cross the 11,000 mark and hoping that the 6% added to the major indexes in March will be seen once again in April as we enter earnings season.

 I’ll admit I’m pretty fired up about earnings myself. As a growth guy, fundamentals are everything to me, and I live for the four times a year when sales and profits are in focus and the noise of Wall Street fades into the background. (Here are my five favorite large-cap picks for this earnings season.)

What’s more, the first quarter of 2009 was arguably the worst part of the recession, and favorable year-over-year comparisons will lead to blowout results for most companies. I expect the S&P 500's operating earnings to be up almost 70% during the first quarter on average. With numbers like that, it’s easy to imagine the market will post significant gains.


So why am I sounding the warning bell?


Well, because earnings have a way of stealing the show -- in good times and in bad. And right now the amazing improvements for most stocks compared with 2009 are masking the fact that things are just less bad. The fact is there are still serious problems with our economy.


After the sunshine of a favorable earnings season fades, the cold reality of these major indicators will be crystal clear. And Wall Street will not be happy.


Consider that after this earnings surge for Q1, The S&P 500’s operating earnings are expected to decelerate rapidly. My calculations show that operating earnings should decline 63.5% from the first quarter, then an additional 33.2% from the second quarter and an additional 24.9% in the third quarter! You could say the past is finally catching up to Wall Street and that the era of low expectations is rapidly coming to a close. 

Easy year-over-year comparisons, a strong global economic recovery and a weaker U.S. dollar in the past year are all helping to fuel bullish sentiment. Technically the average fourth-quarter earnings for the S&P back in 2008 were actually negative, given the economic meltdown, so positive earnings over negative earnings generated results that were off the chart. But does anyone really think the U.S. economy was firing on all cylinders in the fourth quarter of 2009 when unemployment was over 10%?


Similarly, first-quarter numbers were cheered as sign of continued improvement. Obviously things are much better than when the market hit its 12-year low on March 9, 2009, but does that mean the markets have nowhere to go but up?


Essentially, the market has been so overwhelmed with wave after wave of strong earnings that this news has overpowered any negative data that previously hindered the stock market. I fully expect that to happen again as we kick off first-quarter earnings over the next several days, and I expect it to be a good ride for a week or two.

But the market has been wearing rose-colored glasses, and I predict it’s about to take them off. And when it does, I expect the market to go sideways at best and suffer a significant correction at worst.


That’s why it’s important for you to enjoy this earnings season -- and use it as an opportunity to identify stocks that are truly succeeding based on their fundamentals. Because mark my words: This earnings season will be the last time investors can bank on easier year-over-year comparisons. From here on out, the market is going to get much more selective and much more challenging.


But here’s the silver lining: As the breadth and power of the market shrinks, the very best companies with true sales and earnings growth will see buying pressure and continued share appreciation. And as the fakers flame out, Wall Street will race to get a share of these fundamentally superior stocks. This upcoming “flight to quality” will be very good for the handful of elite companies that are offering innovative new products or fighting to expand market share and keep costs down even in these challenging times.

My advice to you is to look carefully at your holdings this earnings season, and bank the profits in those stocks that aren’t really outperforming the major indexes. Then take that cash and pour it all into stocks that are showing real top-line and bottom-line growth -- not just looking better compared to the worst market since the Great Depression.


As the market realigns to favor a small group of companies with elite fundamentals, investors had better take notice. My top stocks for the recovery are a great place to start.


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