A rough start to 2007

Market Outlook
Earnings Could Spark Surprises
Bernie Schaeffer, Option Advisor 04.02.07, 11:52 AM ET

04.03.07  NYSE move to higher terrotory 12500  Naz 1450  SP 1440

It was with a sigh of relief that traders were able to finally close the books on what turned out to be a rough start to 2007.

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The Dow Jones industrial average continued the uptrend that it started in mid-2006 until late February, when the broad market hit a rough patch called "subprime" and dropped roughly 6%. Despite bouncing back from its lows, the Dow finished the first quarter with a loss of 0.87%, its first quarterly loss since the second quarter of 2005.

Elsewhere around the broad market, the S&P 500 Index (SPX) ended the quarter with a meager 0.18% gain, and the Nasdaq Composite edged 0.26% higher. On the other hand, the small-cap Russell 2000 Index outstripped them all, sprinting an impressive 1.66% higher for the quarter. Furthermore, the bulls might conclude that such figures are not too bad considering the bullets that were fired at the market during the course of the first quarter (from a big sell-off in Chinese stocks, subprime and housing woes, and Alan Greenspan's recession warning).

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The first quarter saw a heavy spike in trading volume in Standard & Poor's Depositary Receipts (amex: SPY). Until February 2007, SPY weekly volume had exceeded 600 million shares just twice, for the weeks ending June 9 and June 16, 2006. It has now exceeded 600 million for four of the past five weeks, including last week. What's more, March marked the exchange-traded fund's highest monthly volume ever.

Looking ahead, we're likely to see a distinct shift in investors' attention away from the ongoing subprime woes and more toward the start of another earnings season. Over the past few years, double-digit earnings growth has been the norm on the Street. Yet, after 14 consecutive quarters of double-digit growth, the SPX's components are expected to notch a gain of just 3.8% in the first quarter of 2007 and roughly 4% in the second quarter. In fact, analysts are expecting full-year growth of just 6.7%, which would be the weakest growth since 2002.

Expectations for the quarter have slid steadily since the start of the year, as analysts have adopted an increasingly negative outlook. At the start of 2007, the average earnings estimate for first-quarter growth stood at 8.7%. However, the forecast has shrunk to less than 4%.

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Overall, energy, industrials and technology are coming up against some tough year-over-year comparisons. In fact, estimates for energy growth were negative near the end of January and have grown to -3% growth. While there is no doubt that earnings growth rates will be a challenge on a year-over-year basis, compared with the past few years, given the recent price action in the price of crude oil, such estimates may be a bit on the low side, in my opinion.

While energy is a sector that is vulnerable to downgrades, given the high percentage of "buy" ratings on the group, bears on the group should note the risk to potential positive earnings surprises during the short term. Thus, when trading this heavily traded sector, we advocate a pair approach, using energy-related ETFs to hedge a bullish or bearish outlook on a particular stock.

As we head into another earnings season, expectations are running extremely low and pessimism is running high, which could make for some very interesting opportunities should some of these companies start releasing earnings that are ahead of the consensus estimate.

Recently, I noted that "the latest short-interest figures were released by the New York Stock Exchange, revealing a 9.5% jump in the shorted shares not yet closed out on the NYSE. The monthly period measured for short interest stretched from Feb. 15 through March 15, encompassing the pullback in the market. Even so, this is an off-the-charts increase in short interest, as my experience has been that these monthly short-interest changes tend to be in the 1% to 2% range."

Well, short interest on the Nasdaq has been released, and bearish bets jumped by a whopping 12.1% in March. The short-interest ratio for the Nasdaq inched higher from 3.5 to 3.7, while the ratio at the NYSE stands at 6.1.

Another interesting data point on short interest comes in the form of odd-lot short activity. The 10-day moving average of odd-lot shorting activity appears to have now rolled over from a very high level. As we enter earnings season, a continued unwinding of this wellspring of pessimism could send stocks soaring higher on any positive news.

Traders are in for another busy week, as a number a key economic reports are slated to hit the Street. Traders will have to sift through the Institute of Supply Management manufacturing and services indexes, March retail sales, factory orders and the all-important non-farm payrolls figures and unemployment rate.