This Is Why the Market Drops Are Brief and Small

October 27, 2021

Posted 9:30 AM ET – PRE-OPEN MARKET COMMENTS WEDNESDAY – The S&P 500 is making new all-time highs as earnings season cranks up. The reaction to mega cap tech earnings has been mixed. Bulls will view this as good news because the results have been strong enough to support extreme valuations.

NFLX and TSLA were able to rally last week after an initial negative reaction while FB and INTC remained weak after heavy selling. MSFT looks strong after posting results while TWTR, AMD and GOOG are flat.

AAPL and AMZN will post earnings after the close Thursday.

These numbers are from Fact Set and they are a week old:

• Earnings Scorecard: For Q3 2021 (with 23% of S&P 500 companies reporting actual results), 84% of S&P 500 companies have reported a positive EPS surprise and 75% of S&P 500 companies have reported a positive revenue surprise.

• Earnings Growth: For Q3 2021, the blended earnings growth rate for the S&P 500 is 32.7%. If 32.7% is the actual growth rate for the quarter, it will mark the third-highest (year-over-year) earnings growth rate reported by the index since 2010.

• Earnings Revisions: On September 30, the estimated earnings growth rate for Q3 2021 was 27.5%. Eight sectors have higher earnings growth rates today (compared to September 30) due to positive EPS estimates and upward revisions to estimates

• Earnings Guidance: For Q4 2021, 8 S&P 500 companies have issued negative EPS guidance and 4 S&P 500 companies have issued positive EPS guidance.

• Valuation: The forward 12-month P/E ratio for the S&P 500 is 21.0. This P/E ratio is above the 5-year average (18.3) and above the 10-year average (16.4).

The momentum has been incredibly strong with gaps higher and stacked green candles closing on the high. The volume is light and that is a sign that there is a seller’s boycott (no one wants to sell). This morning the S&P 500 is set for another gap up (20 points).

These are the market forces in play and the bullish forces are winning.

Reasons to be bullish:

1. Interest rates are not keeping pace with inflation (negative real returns) so investors see stocks as an attractive investment alternative.
2. Corporate buy backs are steady.
3. The long term trend is up and the market formed a base at the 100-day MA.
4. We are heading into a seasonally strong period.

Reasons to be bearish:

1. Stock valuations have not been this high since the 2000 tech bubble.
2. The Fed may start tapering in November.
3. Hourly wages are rising quickly and this will bite into profit margins.
4. Raw material costs are rising quickly and that is inflationary.
5. Global economic growth is sluggish because of supply disruptions.
6. Electricity is being rationed around the globe due to energy supply issues.
7. China is seeing a rise in corporate defaults. This could spark credit concerns.
8. Analysts are downgrading earnings expectations at a fast clip.
9. This was the heaviest selling we have seen in a year.

The reasons to be bullish are winning the battle. Rising inflation, historically low interest rates and a dovish Fed are making bonds an unattractive investment. The printing presses are running full tilt and that money is finding its way into stocks. FB got trashed after earnings so what did they do? They announced a $50 billion share buy-back. Companies have been issuing cheap debt for years and using the proceeds to buy back shares. This might seem insignificant, but trust me it is not. As an example, AAPL has reduced its outstanding shared by 25% in the last 5 years. For the S&P 500 the number of shares outstanding has been reduced by 50% in the last decade. On a short term basis, that buying supports the stock. On a longer term basis extreme liquidity (from constant money printing) results in mountains of money chasing fewer shares (tighter supply of shares and increasing demand = higher prices). These are powerful forces and it explains why we do not see any big market declines.

A big credit crisis is the only thing that can topple this market and I do not see one… yet. China is worth keeping an eye on. An interest rate spike would also be problematic for the market, but that would take time to unfold. Right now the prevailing thought is that inflation will be temporary. If that changes we could see that spike in yields regardless of Fed policy (the market will force the Fed to raise rates by selling bonds).

Swing traders should wait for the FOMC reaction next week. If the market holds up well you can sell out of the money bullish put spreads on the notion that we will see a strong bid into year end.

Day traders need to look for two-sided action. There have been nice opportunities on both sides of the market. I don’t expect to see any monster bullish trend days like we had last week. Set passive targets and know that the market will reverse when the current momentum runs out of steam. Buying dips once support has been established is the best day trading approach because you can join the longer term market uptrend. Chinese stocks have been great shorts.

Support is at SPY $454. Resistance is the all-time high
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