With two thirds of the S&P500 and DJIA companies reporting earnings – and 66% reporting upside surprises – we thought it an opportune time to review what is driving the overall numbers. For many companies, there seems to be unsustainable factors helping them hit their targets. Is the glass half empty as the Bears are claiming, or is it half full, and sustainably so, as the Bulls have said?

Last quarter (Q1 2003), the SPX benefited from the dramatic one-time gains from the energy sector. A whopping 180% earning’s growth was tied to a short lived war-caused spike in the price of crude. Energy revenue grew 46%, versus expectations of 12% gains for Q2 ‘03.

One-offs are also seen helping other sectors this quarter. Manufacturing and Cyclical firms are reaping the benefits of the weak dollar as favorable currency translations have been helping those companies beat their numbers (see CAT, UTX, DOW, and DD). Finance firms have also benefited from events which may not be sustainable: The rally caused a spike in trading, helping both online brokers and traditional asset managers alike; Ultra low interest rates benefited banks, credit card issuers and mortgage lenders. In our opinion, if rates continue moving back towards historical norms, banks and traders will be hurt on both the top and bottom lines.

But the Bulls have some positives on their side. Barron’s reported that “Nasdaq short interest rose to another record in July, representing the reservoir of skepticism that keeps building.” That’s the wall of worry the market needs to climb. Barron’s also notes that “just-reported figures show the biggest drop in NYSE short-interest in a year.”

What we infer from this is that short interest – just like stocks – goes through its own form of rotation. Earlier in this rally, we saw evidence of market neutral players putting on a Nasdaq vs. SPX paired trade: Long hi beta momentum/lousy fundamental Nasdaq names, Short stodgy cyclicals with improving fundamentals.

That trade may be unwinding now. With signs of the economy improving, and the Nasdaq quite pricey, we may even see the trade reverse. The new paired trade is long cyclicals, short Nasdaq. That could give quality names a chance to catch up with the pricey runners which may be overdue for a pullback anyway.

Gradually improving economic fundamentals, and more attractive valuations support this rotation. Holders of expensive Nasdaq names are urged to tighten stops, and look towards quality SPX names for the next leg up.

Chart of the Week
The Dow Industrial Average has consolidated into an ascending triangle. We should expect continued consolidation within the 500 point trading range between 8950 and 9450.

6 Month Dow Industrials Average Chart
DJIA Chart.jpg
Source: Arms Advisory
A breakout above the top of the triangle bodes well for a measured move to about 10,100.

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Quote of the Day: “Is it so bad, then, to be misunderstood? Pythagoras was misunderstood, and Socrates, and Jesus, and Luther, and Copernicus, and Galileo, and Newton, and every pure and wise spirit that ever took flesh. To be great is to be misunderstood.”
-Ralph Waldo Emerson

Category: Finance

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