For the past month, much of the media attention focused on the financial markets has been about corporate earnings. They are important, because the foundation of our capitalistic system is the concept that individual investors can participate in the profits of these corporations. Without earnings, there are no profits to share.

Many of the media reports the past few weeks have been about how second quarter earnings reports for many corporations have been better than expected. In fact, a report from Thomson Reuters news service showed that on July 24, with 30% of the S&P 500 companies reporting, only 16% of the companies failed to meet earnings expectations. Seventy-six percent exceeded projections and the remaining 8% matched expectations.

Unfortunately for investors, whether or not a company exceeds its earnings forecast says nothing about its profitability. For example, consider this report from Money Daily: “After the bell on Tuesday, chipmaker Intel reported second quarter earnings results far ahead of Wall Street expectations. That was enough to give investors confidence that the economy was continuing to mend - albeit slowly - and that stocks - especially tech companies with strong balance sheets - would weather the storm and produce solid results.”

Based on that commentary, one might assume that Intel was reporting a profit. In actuality, Intel lost 7 cents a share. That compared to a gain of 28 cents a share for the same quarter in 2008. Wall Street was expecting Intel to lose 8 cents per share. So the reported loss was better than anticipated. Even though Intel lost money and overall earnings were down dramatically from the previous year, it was among those 76% of companies whose earning exceeded expectations.

Intel closed at 16.83 the day before the report. The next day it gapped up to open at 17.99 and it closed at 18.05

In reality, earnings forecasts are not very important because the actual number can end up being far different than the forecast. The forecasts are the first glimpse of what the real quarterly numbers might turn out to be so they receive lots of media attention. Revisions made weeks later with more accurate numbers often fail to generate much interest or publicity.

A Jun. 19, 2009 report from Comstock Partners Inc. noted: “We are surprised to see so many analysts and portfolio managers discussing the first quarter’s earnings for the S&P 500. Almost everyone believes that the earnings have come in above the forecasts and the only disappointment came from revenue shortfalls.

“We wrote a report on April 16th (the beginning of 2009 first quarter earnings announcements) about a discussion in the Wall Street Journal on whether the $13 of estimated ‘operating’ earnings for the first quarter would hold up. We concluded that the earnings would not match the estimate and we quote from the comment, ‘we don’t expect them to reach the $13 estimated for the first quarter.’ Now that the earnings season has ended, the first quarter earnings are now a lot clearer and look to be just above $10. …”

As demonstrated with the Intel example above, the corporations and Wall Street benefit when earnings exceed forecasts. So it is to their advantage to make certain that their forecasts are ridiculously conservative. It is kind of like asking students to choose their own grades. Given that opportunity, not many will fail.

The reality of the current situation is that no matter what the media is reporting, corporate earnings are dismal. Earnings per share of the S&P 500 are at their lowest levels since the index was founded in 1936.

Below is a chart that shows the quarterly P/E ratio of the S&P 500 based on trailing 12-month earnings. This information comes directly from Standard & Poor’s. At the end of 2008 (the last quarter for which final data is available), the P/E ratio of the S&P 500 was at 60.70, its highest recorded level. Although final data was not available to include in this chart for the past two quarters, on the Standard & Poor’s web site as of June 30, 2009 the P/E ratio of the S&P 500 (based on as-reported earnings) was reported as 134.01–more than double the highest level shown on this chart. Historically, the all-time average P/E ratio of the S&P 500 has been about 15.

A P/E ratio can be reflective of a company’s financial strength or weakness. It is calculated by dividing a company’s stock price by its earnings per share. Stocks with lower P/E ratios are generally assumed to be more attractive. While a low P/E is not a guarantee that a stock will perform well, it can be a useful tool to help assess earnings potential. Since the stock price also reflects the investors’ expectations regarding the growth and future development of a company, a high P/E can be the result of investors’ speculation.

Most financial advisors would recommend that their clients avoid stocks with high P/E ratios because it is an indication that the stock is overvalued and carries potentially high risk. For example, at the end of 1999 when the technology sector reached its highest levels of “irrational exuberance,” Microsoft (MSFT) shares were trading at about $60 with a P/E of 76. A year later the share price had declined to $23 and the P/E was 30. Today the share price is about $24 and the P/E is about 14.

In this instance, the high P/E ratio of the S&P 500 is primarily reflective of a lack of earnings rather than of high investor expectations. Let the significance of that sink in for a minute or two. Standard & Poor’s describes the index as: “the best single gauge of the U.S. equities market, this world-renowned index includes 500 leading companies in leading industries of the U.S. economy.” And since peaking in the third quarter of 2007, earnings for this icon of the U.S. stock market have fallen more than 95%. Never in the 73-year existence of the index have earnings been at this low level.

In spite of the fact that earnings have never been this low, the S&P 500 has risen more than 40% since bottoming at about 676 in March 2009. If the index were currently trading at the historical average of about 15 times earnings, the S&P 500 would now be well under 100, rather than approaching 1,000.

What does all this mean for Strategis Financial Group and its clients? For us it is just additional evidence that market risk remains  high. At some point improving technical indicators could cause us to begin to ease back into the markets no matter the P/E ratio of the S&P 500. But because so many fundamental indicators remain negative, re-entry into the equity markets must be cautious and measured.
F.S.

For months we’ve been warning investors to stay out of the markets because risk was too high to warrant being invested. This week’s market action is forcing us to reconsider our position. That does not mean we are advocating jumping into the market with both feet. However, for some speculative or aggressive investors, it might be time to test the water with a toe.

From a fundamental perspective, risk in the economy and in the financial markets remains high. Although there have been a few highly publicized positive surprises, second-quarter earning reports so far have been mixed. Unemployment is high and is expected to go higher.

The reason we are rethinking our position is because of changes to the technical situation. The black line on the chart below shows the daily price movement of the S&P 500 over the past two years. The gold line is a 200-day simple moving average (MA). Notice that the index broke above this moving average at the end of May, but for all of June, it hovered right on the 200-day MA as the markets corrected. But in the past week, the S&P 500 has advanced strongly above the MA.

The pattern for other major indices is similar with the Nasdaq showing the greatest strength and the Dow looking almost identical to the S&P. The 200-day MA is a long-term indicator and it is often used to help identify changes in long-term market trends. The last time the S&P moved this strongly above its 200-day MA was in September 2007. It held its ground for about a month until the market peaked and rolled over–precipitating the bear market that has persisted ever since.

The middle portion of the chart is a moving average convergence divergence (MACD) of the S&P. About a week ago it crossed over and made a move into positive territory. Normally that would indicate that the market has enough positive momentum to sustain an advance.

The bottom portion of the chart is a relative strength index (RSI). During periods of market strength, the RSI usually trends above 50. In June the RSI had fallen well below 50. But again, over the past couple of weeks the RSI has climbed sharply and is now showing surprising strength.

Of course this could all change very quickly, which is why we must still advise investors to use caution–particularly conservative investors and retired investors who cannot afford to take any losses. But for more aggressive investors, we have reached a point where taking some carefully considered long positions again makes sense.
F.S.

After strong earnings reports by Goldman Sachs and Intel this week, major market indices posted impressive one-day gains Wednesday with the Dow and S&P up about 2% and the Nasdaq up more than 2.5%. While it is nice to see some positive numbers, these gains emerged amid of plethora of reports showing continued economic weakness.

The past couple of weeks bad unemployment numbers have been a drag on the markets. Tuesday there was an op-ed piece in the Wall Street Journal explaining that the real jobless numbers are worse than government reports indicate. Written by U.S. News & World Report Editor-In-Chief Mortimer Zuckerman, the article was titled: “The Economy is Even Worse than You Think.”

He cited the fact that instead of laying off employees, many companies are asking workers to take unpaid leave or to work fewer hours. The average work week in the private sector is now just 33 hours–the lowest level since the government began recording such data 45 years ago. The average length of official unemployment stretched to 24.5 weeks–also the worst since tracking began.

Instead of the 9.5% rate reported by the Bureau of Labor Statistics, Zuckerman wrote that when those who have taken part-time jobs are added in, the total jobless rate is at least 16.5%.

This week the Federal Reserve released a forecast that predicted the jobless rate could rise to as high as 10.1 percent in 2009, compared with the previous forecast of 9.6 percent. The report indicated that most Fed policymakers said it could take five or six years for the economy and the labor market to regain long-term stability. In the meantime, officials reported “the economy as still quite weak and vulnerable to further adverse shocks.”

In spite of the Obama administration’s efforts, the housing market also remains weak. According to a report released Thursday by foreclosure listing service RealtyTrac Inc., the realty crisis meant more than 1.5 million homes faced foreclosure in the first six months of the year. That is a 15% increase over the prior six-month period. The report said foreclosure filings rose more than 33 percent in June compared with the same month last year and were up nearly 5 percent from May. Foreclosures are not expected to peak until the middle of 2010.

Thursday the U.S. Treasury Department announced that in May, foreigners actually sold $19.8 billion more long-term U.S. securities than they purchased. That compared with net purchases of $11.5 billion in April. That is significant because one of the major means the U.S. has to try to buy its way out of this economic crisis is by selling bonds. The last time foreigners sold more long-term U.S. securities than they purchased was in January. That month sales exceeded purchases by $36.8 billion.

The reason I am bringing all this negative economic news to the forefront is simply to point out that the risk of another significant market downturn remains very high. Some analysts predict that the economy and the markets will not bottom until 2010. We have no way to know exactly when the economy will turn around. But right now there is a distinct possibility that stocks could decline an additional 20%, 30%, or even more.

Big one-day up moves in the markets like we saw this week are tempting, because investors want to avoid being left behind when the next bull market begins. But enthusiasm for potential profits needs to be curbed until there are definite signs that the economy has the strength to sustain long-term market momentum. So far that does not seem to be the case.
F.S.

This week has shown continued signs of a market downturn with major market indices declining. This is a broad-based downturn that is also impacting market sectors that have shown plenty of recent strength.

The chart below shows a candlestick chart of the S&P 500 like the one we used last week. For comparison, I’ve added exchange traded funds representing gold and oil. Both of these sectors have been much more volatile than the S&P 500. For the calendar year, each has had strong rallies and major corrections. And after all the peaks and valleys, OIL and the S&P 500 have lost money for the year. GLD remains slightly ahead.

The gold line on this chart is streetTRACKS Gold Trust (GLD). Investors tend to seek the safety of gold during major market corrections and during times of anticipated inflation. But in spite of the massive injections of dollars into the money supply, so far inflation remains contained. The recent downturn in gold could well be because gold traders realize that with the seriousness of the current recession, deflation remains a bigger threat than inflation.

The blue line is iPath S&P GSCI Crude Oil Total Ret Index ETN (OIL). Since late February, the price of oil rose sharply on the expectation that the recession would soon end and demand for crude oil products would increase. Over the past month, with economic fundamentals showing little improvement, the price of oil began to slide.

The S&P 500 has fallen about 5% from its June high. The next area of strong technical support is about 5% lower than the current level. One of the major factors determining whether it can hold there will likely be second quarter corporate earnings reports that are just starting to trickle out.

Our assessment continues to be that market risk remains very high at this time. As a result, we recommend remaining in a money market fund until we start to see substantial evidence that the market is improving and risk is declining.
F.S

Two weeks ago I was preparing for a short vacation and hoping that by the time I made it back, the market would have made a decisive move either up or down. Unfortunately, that has not occurred and stocks still seem to be struggling to find a direction.

Ever since the market began to rally in March, we warned that the long-term trend remained negative and risk did not warrant jumping back into the market. The basis for that reasoning are numerous economic factors that continue to reflect an economy mired in recession rather than one that is about to start a new growth surge.

Today’s unemployment numbers might be the catalyst for helping investors and traders to see things as they really are. It is hard to make an argument that the recession is over when 9.5% of the population is jobless.

The chart below shows performance of the S&P 500 index during 2009. This type of charting is called “candlesticks.” A description of this type of charting can be found at: http://en.wikipedia.org/wiki/Candlestick_chart. For our purposes today, all one really needs to understand is that the red candlesticks reflect days when the S&P went down and white or open candlesticks show days when the index rose.

By looking at color alone, one can see that market weakness prevailed for the first couple months of 2009. In March and April, the white candles were prevalent. In May and June, however, the picture is mixed and the index has made virtually no headway. The picture for the year is two months negative, two positive and two sideways.

The gold line is a simple 50-day moving average. Two weeks ago the 50 and 200-day moving averages had converged and the S&P 500 was resting right on both. Over the past two weeks, the index moved slightly above both moving averages, but today’s action brings both back in convergence again.

The bottom portion of this chart is a moving average convergence divergence (MACD). It continues to move toward a negative level, indicating that weakness is in control. This indicator has not reached an oversold level indicative of a market turnaround. So even if this sell-off does not accelerate, it would not be unusual to see the S&P 500 continue to drift in a sideways pattern for another few weeks.

Markets will be closed tomorrow for the Independence Day holiday. Have a great holiday and remember to be grateful for the freedoms we enjoy.
F.S.