Gap and trap

The market is following the gap and trap pattern. The morning strength does not lead to more strength in the afternoon. The month end effect will ensure that we stay in range. The action typically sucks in bulls and unnerves the bear.

Earnings so far are much better than expected.

Through the close on Tuesday, a total of 212, or 42.4%% of the S&P 500 stocks have reported their second quarter results (defined as the fiscal period ending in May, June or July). Thus far the results have been very encouraging. The median year-over-year growth rate is 13.1%. As in recent quarters, positive surprises have been swamping disappointments, with the ratio currently running at almost 5:1. The median surprise has been 3.4%. This is almost identical to the 3.5% median surprise that this same group of companies delivered in the first quarter. In every sector, positive surprises far exceed disappointments.
It looks pretty certain that we will have yet another quarter of double-digit year-over-year growth in earnings. If anything, the 13.1% growth shown so far is more likely to increase than decline when all the results are in. The forward looking growth rates, for the third quarter, and 2006, are the median growth rates of only those firms that have reported so far, not the sector or the S&P 500 as a whole. The median expected 2006 growth for those that have reported is 10.5%. However the median expected 2006 growth rate for the S&P 500 as a whole is 12.2%. Every sector except the two Consumer sectors is currently showing double-digit growth for the quarter. Thus, more of the high expected growth firms, at least for the year as a whole, are yet to report.

For every sector except Materials, growth is expected to slow, often significantly, in the third quarter. Many firms which may have reported better than expected numbers for the second quarter have issued downbeat guidance for the second half. A great example of this is among the Homebuilders, where four of the five firms in the sector have already reported for the second quarter, and all had positive surprises. On the other hand, all made it very clear that it was the last good quarter to be expected from them for quite some time. For several quarters now, the “next quarter” has been expected to be softer than the “current quarter”, at least until that “next quarter” gets reported. In other words, it appears that firms are following an under promise and over deliver strategy with respect to their guidance.