Advisers eyeball key 1Q earnings to forecast market

Even with the S&P 500 up 9% this year, there is a simmering unease among financial advisers and market watchers in anticipation of the flood of corporate earnings reports expected over the next two weeks.

Fresh concerns about government debt in Europe, weak U.S. jobs numbers and a volatile week for the equity markets all stand out as reminders that the economy remains fragile and this recovery is anything but normal.

In fact, the Dow Jones Industrial Average finished down 137 points Friday, capping the worst week of the year.

“I think this earnings season is very important, and the market's direction over the next several weeks will depend on the strength of those earnings reports,” said Adrian Day, president of an eponymous $165 million financial advisory firm. Although the earnings season officially started last week, it moves into high gear this week.

Despite solid stock market performance, Mr. Day said his clients are “generally very concerned about everything from Europe to U.S. economic weakness.”

“I'd say my clients are as concerned today as they were [at start of the financial crisis] in 2008,” he added. “They're not looking specifically at things like unemployment, but they're focused on the overall economy and the political mess.”

Market watchers and financial advisers alike sum up the current environment as an example of a disconnect between what's happening on Wall Street and what's happening on Main Street.

“One of the things holding everything up right now is the positive wealth effect of the gains seen in the stock market,” said Frank Barbera, a portfolio manager at Sierra Investment Management Inc., which manages $1.5 billion.

Yet while the stock market has been relatively strong and steady this year, one need only look at the direction of flows into mutual funds to see that most investors aren't participating.

NET OUTFLOWS

According to the Investment Company Institute, equity mutual funds have experienced more than $180 billion in net outflows since April of last year, which was the last time stock funds finished a month with net inflows.

Over the same time period, bond funds had more than $190 billion in net inflows.

“Main Street is not buying in right now, but Wall Street is full steam ahead,” said Kevin Mahn, chief investment officer at Hennion & Walsh Asset Management Inc., a financial advisory firm with $425 million under management and supervision.

Although he has become more bullish with the portfolios of existing clients, he has seen a common theme of caution and concern during interviews with prospective clients.

“We're hearing a lot of people saying they still don't want to move in to the stock market for fear of a large correction still to come,” Mr. Mahn said.

That kind of cautious investor sentiment makes the stock market particularly vulnerable to this week's earnings reports, he said.

“Investors are getting a little spooked because they're seeing rising gas prices, higher commodity prices, as well as weaker jobs and housing reports,” Mr. Mahn said. “I'm waiting for first-quarter earnings, because if we see some negative surprises or misses, you could see further retrenchment by the stock market.”

If corporate earnings really do represent the glue holding everything together right now, investors might be able to breathe at least a temporary sigh of relief.

“We think the market is setting up for a bit of a positive surprise in terms of earnings,” said Jim Russell, chief equity strategist at U.S. Bank Wealth Management, which has $103 billion under management. “The markets are bracing for, and already factoring in, year-over-year earnings gains by the S&P 500 of less than 1%, but we think it will be closer to 4%.”

Mr. Russell is particularly bullish on the technology, industrials and consumer staples sectors, which he expects will produce enough positive earnings growth to lift the lower-performing sectors of the S&P 500.

Mr. Russell, who sees the glass as half full, thinks that market watchers are overlooking the impact of consumer spending, which represents 70% of the economy.

“Consumer spending is on the rise, and car sales have been very strong,” he said. “We think the U.S. consumer is a much greater participant in the earnings stream.”

But even if consumer spending is strong enough to boost first-quarter earnings, there remains concern over how much more support consumers can continue to provide to the overall economy.

BIG SQUEEZE

Mr. Barbera said that by just about any measure, the consumer in general — and household income in particular — is being squeezed by rising prices and lower wages.

The annualized three-month moving average of inflation, including food and energy prices, as measured by the Consumer Price Index, is at 2.5%, which is above the Federal Reserve's 2% inflation target.

Even worse, the three-month moving average of the Producer Price Index, which moves ahead of the CPI as a measure of wholesale prices, shows an annualized inflation rate of more than 8%.

“Over the last six months, all the headline data points have suggested that the economy is improving, but when you drill down, it looks like more of the same,” Mr. Barbera said. “We're labeling it a subdued recovery because this is not anything like any recovery we have seen in the past.”

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