Q2 earnings: A catalyst or a catastrophe?

Adding to the positive sentiment were reduced concerns over the financial health of Europe. If we are to look at a country's currency as a proxy for its economic health and fiscal policies, then the fact that the euro has rebounded to a six-week high is likely an indication that investors are becoming more comfortable with the sovereign debt issues in the eurozone. While the problems have far from disappeared, the developments, at worst, seem to be stabilizing.

Double-dip fears were also allayed somewhat after the International Monetary Fund (IMF) raised its global growth prospects for 2010, although to be fair, it also warned that the financial market turmoil has increased the risks to the recovery. The IMF now sees the global economy growing at a 4.6% rate, up from its prior estimate of 4.2%. The IMF also raised its expected growth rate for the United States to 3.3% from 3.1%.

	Index	Closing Price 7/9/2010	Week Ending 7/9/2010	Year to date through 7/9/2010
	Dow Jones Industrial Average	10197.72	5.28%	-2.21%
	Wilshire 5000 Total Market	11118.67	5.37%	-2.66%
	S&P 500	1077.93	5.41%	-3.33%
	NASDAQ Composite	2196.45	5.00%	-3.20%
	S&P/TSX Composite	11570.45	3.34%	-1.50%

Earnings season begins. Second quarter earnings season kicks off in earnest this week. With the recent decline in the markets, investor sentiment has generally soured and expectations have been reeled in. This, coupled with attractive valuation levels, could set the stage for an earnings-induced rally. According to Bloomberg data, second-quarter earnings are expected to be up a robust 34%, although traders will likely focus on forward guidance and look for clues as to whether the problems in Europe are filtering through to corporate bottom lines.

In addition to the forward-looking guidance from company management, investors also appear to be waiting for the outcome of the stress tests being performed on 91 European banking institutions. The test results are due out later this month and are expected to shed light on the health of the European banking system.

Corrections are normal and healthy. After gaining almost 80% from the March 2009 low to the recent peak in late April, the S&P 500 had pulled back by as much as 15%. The weakness has been prompted by softness in economic data, coupled with external uncertainties such as the oil spill in the Gulf of Mexico, geopolitical tension and European debt issues, among others. While corrective phases are nerve wracking, they also tend to serve a purpose, in that they act as a mechanism to filter out the weak holders and allow for shares to be repositioned to longer-term investors at more attractive price points.

It is also comforting that the correction is occurring at a time when inflation is subdued, interest rates are very low, valuation levels are attractive and sentiment levels have turned very bearish. On the last point, the American Association of Individual Investors (AAII) recently reported that the percentage of investors who are bullish on the market's outlook over the next six months had fallen to 20.9%; this is the lowest reading since March 5, 2009, when bullish sentiment fell to 18.9%.

Remember that in their simplest form investment decisions are made with emotions--fear and greed. Investors tend to be overly greedy at market tops and very fearful at market bottoms. Emotional investing also tends to be contrarian in nature. To quote Warren Buffet, "We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful." In other words, the best time to buy is when negative sentiment is near extremes.

Jobless claims: Less bad. Last week's economic calendar was very light and the data that was released was generally mixed. On the jobs front, the U.S. Labor Department reported that initial jobless claims during the week ended July 3 fell 21,000 to 454,000. The report was slightly better than the 460,000 expected by economists. The four-week moving average--which helps smooth the week-to-week volatility--fell to 466,000 but remains just off the highest level since early March.

Continuing claims--the ongoing number of people collecting unemployment benefits--fell by 224,000 to 4,413,000 and now stands at the lowest level since November 2008. Meanwhile, The Conference Board reported that its Employment Trends Index (ETI) rose 0.6 to 96.7, the highest level since November 2008. Additionally, the prior month's reading was upwardly revised to 96.1 from 95.7. The June increase was the 11th in a row, suggesting a gradual improvement in labour market conditions.

Technicals. Technicals were also likely at work as the S&P 500 broke through the 1040/44 resistance area and the Dow moved back above the psychologically important 10,000 level. While it is probably still too early to pass the baton back to the bulls, the near-term momentum has definitely taken on a more positive tone.

Looking ahead. The beginning of the second quarter earnings season features Dow-component Alcoa scheduled to report results after the close on Monday. This week a total of 23 members of the S&P 500 are scheduled to report results followed by 131 members the following week. The economic calendar also heats up with reports on retail sales, regional manufacturing and consumer and producer inflation. Also of interest will be the vote on financial regulatory reform. The passage of reform would help remove the regulatory uncertainty and allow Wall Street to figure out how to work within the new rule structure.