Be Ready for the Rally's End

09/24/2010 11:30 am EST

Focus: MARKETS

Jim Jubak

Founder and Editor, JubakPicks.com

September's big market move faces a few hurdles with earnings season closing in. Here's why it's likely to stall, how to tell if it is, and how to prepare.

So what could stop this rally?

Now that it has broken through resistance at 1,127 and 1,130 on the Standard & Poor's 500 Index, what could prevent this rally from running straight through September (historically the worst month for stocks, going back to 1928) into October (historically the second-worst month for stocks), then finishing 2010 with an end-of-the-year rally?

In other words, what should you be afraid of—and when?

Just one word. Are you listening, Benjamin? Earnings.

But probably not in the way—or with the timing—that you would expect.

I'm not worried about unexpectedly bad reports in the third-quarter earnings season that gets under way Oct. 7, when PepsiCo (NYSE: PEP) and Alcoa (NYSE: AA) will release their latest numbers. If that were the worry, I'd expect the rally to stall somewhere after earnings season started, on actual reports of bad news.

Instead, I'm worried that the stall will come before earnings season starts, with investors deciding to take their good September-rally profits and avoid the risk of disappointing earnings. If I'm right about that timing, stocks might actually be ready to resume their rally around Oct. 20—after the dip—as earnings season ends.

(And that depends, of course, on what the polls say then about the November elections. Polls that show a Republican runaway will leave my estimate of timing intact. Polls that show the Democrats closing in could delay the start of any rally. Wall Street, if you haven't noticed, is rooting—and voting with its campaign contributions—for Republican victories in November.)

Time to take profits?

Let me explain the logic of that timing. Assume that you're an investor looking at gains like these (and I hope you are) from the Aug. 26 (or thereabouts) low:

  • Mining-equipment-maker Joy Global (Nasdaq: JOYG), up 30.4% as of Sept. 22.
  • IPod-, iPhone- and iPad-maker Apple (Nasdaq: AAPL), up 19.4%.
  • Copper and gold producer Freeport McMoRan Copper & Gold (NYSE: FCX), up 27.5%.
  • Truck-engine-maker Cummins (NYSE: CMI), up 22.6%.

There's even been a good rally in some of the market's most beaten-up stocks. Gulf of Mexico disaster stock Transocean (NYSE: RIG) gained 17% from Aug. 26 to Sept. 22.

So what are you thinking as earnings season approaches?

You're thinking, I've had a big gain. Should I let it ride and bet on earnings season delivering an upside surprise?

In many cases, an earnings surprise is what you'll need to lift shares after this rally. The consensus is, in many cases, already built into the stock price. After all, Wall Street analysts have had months to tune and fine-tune their estimates. And in these days, when investors can get analyst estimates from everybody from online brokers to CNBC to MSN Money and Yahoo Finance, these numbers aren't exactly secret.

|pagebreak|

So "everybody" knows that Wall Street expects Apple to report fiscal-fourth-quarter earnings of $3.97 a share Oct. 19 (the date is unconfirmed). That would be earnings growth of 118% from the $1.82 in earnings per share reported for the company's fourth quarter of 2009.

Even for Apple, significantly beating an earnings increase of 118% isn't easy. That's a bar that's likely to make some investors nervous and willing to take profits before the actual earnings report comes out.

It's not just hot stocks such as Apple that face this kind of hurdle. Analysts project Cummins, for example, will report earnings of $1.39 a share Oct. 26, up from 56 cents a share in the corresponding quarter of 2009. That'd be an Apple-like 148% increase.

It's not that companies can't beat earnings forecasts like these. (In fact, in the case of both Apple and Cummins, I think the odds are pretty good they will.) It's just that what we know of investor psychology, especially after two bear markets in less than ten years, argues that many investors won't want to take the risk. Better profits in the hand than promises of future gains.

Take it to the bank?

If there's a pullback, I think we'll get a sense of how deep it will go based on earnings reports from the big banks that start arriving with JPMorgan Chase (NYSE: JPM) on Oct. 13 and continue through Goldman Sachs (NYSE: GS) and Bank of America (NYSE: BAC) to Wells Fargo (NYSE: WFC) on Oct. 20. If these banks deliver solid earnings surprises, investors will become less nervous about what other companies will report, and any pullback will be muted.

Unfortunately, the news isn't likely to be too good for big banks this quarter, because trading volumes have been low, which will cut into revenue and earnings from trading. JPMorgan Chase, for example, recently told analysts that trading revenue in the third quarter has been "not that dissimilar" to the second quarter. The bank reported a year-to-year drop in trading revenue in the second quarter.

Right now, analysts expect pretty subdued growth in the third quarter. The consensus on JPMorgan Chase is for earnings to grow to 89 cents from 80 cents per share in the third quarter. That's growth of just 11.25%.

I see two dangers here: First, there is the possibility that banks won't surpass even these low growth estimates. Second, there's the possibility that even meeting or slightly beating an 11.25% forecast won't be enough for investors who saw a 53.5% earnings surprise above the consensus forecast for the second quarter.

Watch bank earnings and the reaction to them for clues to how big a pullback earnings worries are likely to cause as earnings season plays out.

How to play the pullback

What do you want to do now on the possibility of a pre-earnings-season pullback?

You can, of course, ignore the whole thing. I don't think a pullback is likely to exceed 100 points—that's less than 10%—on the Standard & Poor's 500. And I fully expect we will see the rally resume in late October or early November.

You can sell now to take profits on some of your winners. That, of course, carries the risk that I'm wrong and that there isn't a pullback at all. One way to reduce the risk of that is to sell winners from this rally that you don't want to own in the next rally. BP, for example, is up nearly 8% from Aug. 26. Do you want to own this oil stock, out of all the oil stocks, going forward?

And, finally, you can put some stops in place—formally with your broker or just mentally—that will trigger a sell if a stock drops more than you can stand. I think this is tricky in a pullback that isn't likely to be very large, but it does give you safety if a pullback is larger than I now imagine. Where do you set stops? It depends on how big a loss you can stand—14%? 7%?—before you get panicky and do something reckless. And it also depends on how disciplined you think you can be on buying back in. Setting a narrow stop—say, a 7% drop—will work only if you're capable of buying back in quickly once you sense the market has turned.

Whether you apply any of these strategies should also depend on how much cash you have in your portfolio. If you've got a lot of cash because you've been waiting for an opportunity to buy in, then raising more cash in a relatively small pullback isn't a priority. You'll have enough to do putting that cash to work without increasing the amount that you want to invest.

(So, for example, both my Jubak's Picks portfolio and my new mutual fund, Jubak Global Equity Fund, are flush with cash. Raising more by selling isn't a priority. But then I also expect a resumption of the rally after a relatively minor retreat.)

For a brief discussion of how deep a pullback might be and what would come after it, see my blog post "Stocks take out the top of the trading range today."

At the time of publication, Jim Jubak did not own shares of any company mentioned in this column in his personal portfolio. The Jubak fund may hold positions in these stocks, and positions may change at any time.

Jim Jubak has been writing Jubak's Journal and tracking the performance of his market-beating Jubak's Picks portfolio since 1997 on MSN Money. He is the author of the 2008 book "The Jubak Picks" and the writer of the Jubak Picks blog. He's also the senior markets editor at MoneyShow.com.

Related Articles on MARKETS