US third-quarter earnings playbook: let price be the guide

US stock indices are lacking direction as we head rapidly into the third-quarter earnings season. Company reports could be the driver the market is looking for, but in the meantime here’s the traders' playbook for the coming weeks.

US flag
Source: Bloomberg

We go into the third-quarter US earnings season with both the US 500 and Wall Street cash about as neutral as you will find. A fresh catalyst is clearly needed and whether this comes from earnings or from some other market event is unclear, but a catalyst is missing and both indices are effectively just moving sideways.

If we focus on the US 500 cash we can see the upside is effectively capped at 2180, while good bids/support has been seen into the 2140 area (highlighted by the blue rectangle). Both the five- and twenty-day moving averages are headed perfectly sideways, while the nine-day relative strength index (RSI) is right on the 50 area. If we focus on market internals we can see 49% of companies are above their 50-day average, while 58% are above their 20-day average. Again, this is about as neutral as one will ever see.

Key trading levels on the US 500

Patience is often required in trading and that’s certainly the case now. Let the market push you into a trade. The playbook, in my opinion, is to go long US 500 on a close through 2180, and short through 2140, adding to short exposure on a close through the September lows and 38.2% retracement of the June to August of 2115.

I always like to start small and when the market proves that my analysis is correct I like to build on that. 

Each US earnings season traditionally gets underway when metals company Alcoa reports its results. That may change as Alcoa is splitting itself up and recently lost its blue-chip status. However, the company reports on October 11 and that marks the unofficial start of earnings season. The focus moves immediately on to financials with Citigroup, JP Morgan and Wells Fargo reporting on Friday.

Different numbers have been banded around, but I see consensus earnings falling around 1% year-on-year. Over the next three weeks we get about two-thirds of the S&P 500 weighted by market capitalisation reporting earnings, with a sizeable 30% reporting numbers between 25-27 October alone.

It’s always important when assessing a company’s earnings to focus on the key inputs and how they compare to the prior corresponding period (ie year-on-year, or quarter-on-quarter). One input many companies will talk about is the US dollar and the US dollar basket price is about 2% higher on the year. That’s a headwind, if not a huge one this time. The brent oil global benchmark is close to 10% lower than this time last year, and one suspects we will see strong earnings declines for energy companies. That being said, chief executives in this space should provide some positive rhetoric about the improving landscape for energy production in the US.

Market participants have certainly been warming to US banks of late given the recent move higher in longer maturity US treasury yields. However, we can see that the benchmark US 10-year treasury is about 50 basis points lower than in the third quarter of 2015. One suspects this is priced into valuations, but it should restrict the earnings potential of the banks. See Chris Beauchamp's analysis.

The bar is elevated

We are used to seeing some 70-75% of companies beating consensus expectations, but the bar is now elevated given the S&P 500 trades on a lofty 17.2 times (aggregate) forward earnings. We are going to need see fairly inspiring rhetoric from group CEOs to justify the 7% sales growth the market is expecting into 2017. Capital management continues to be an issue and what will we see in the way of increasing share buybacks or dividend increases? When there is a belief that we could see bond yields rise there is a cost of capital on a relative basis if holding stocks for income.

It’s also important to remember we are in a blackout period in which companies are not allowed to buy back stock in the market. This has been a huge source of support for US indices over the years, so poor earnings numbers could resonate more.

Whether the third-quarter earnings period turns out to be the catalyst the market desperately needs is yet to be seen, but I would be looking at price as a guide and specifically use a daily close through 2180 to increase long exposure and a break through 2140 and subsequently 2116 to build short positions. 

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