Earnings May Be the Rx for Volatility Fatigue

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The coming earnings season might restore a focus on fundamentals, after weeks of sharp market swings.
Vital Signs

A search on the Website of the DSM-V, the abbreviation for the bible of psychological disorders, reveals no entry for "volatility fatigue," but given its growing prevalence on Wall Street, there soon might be one.

The stock market again zigzagged through the week, in keeping with its schizophrenic nature since early August. Shares finished about 2% higher on the week, sandwiching a poor Monday and Friday around a strong midweek showing.

Money managers we spoke with, almost to a man and woman, threw their hands up in surrender and fatigue. This isn't a fundamental market to pick stocks. The complaint goes along these lines: I can make confident picks about earnings, but not about whether or not there will be a full-blown euro-zone sovereign-debt collapse. (For more on that, see Follow Up.)

But we are only being partly facetious. As an anecdotal measure of the kind of volatility suffered since the market's gyrations began Aug. 2, consider that in three of every four trading days since then, the Dow Jones Industrial Average has produced either a negative or positive triple-digit close. Roughly that translates into almost a 1% daily move.

Last week, the Dow closed at 11,103.12 up 1.7%, while the Nasdaq Composite finished at 2479, up 3%.

The Standard & Poor's 500 index gained 2% to 1155.46. In the way of technical analysis, the S&P 500 did fall as low as 1075 briefly Tuesday, more than 20% down from its 2011 high of 1363.63, set April 29. It turned higher by the end of the day, thereby avoiding the technical definition of a bear market.

"We are getting into a pattern of seeing negative Mondays after troubling weekend news out of Europe," says Brian Belski, the chief investment strategist at Oppenheimer.

In the main, the U.S. economic data were decent this week, supporting a move upward from mid-Tuesday on, he adds. On Friday, the U.S. Labor Department said employers added 103,000 jobs in September, above consensus. The nation's unemployment remains at 9.1%.

Perhaps some semblance of normality—that is, where corporate fundamentals matter—will return this week as the third-quarter earnings season kicks off, with the first big report due from Alcoa (ticker: AA) on Tuesday.

A bullish Belski says that, with the market in a funk, the stage is set for an upside surprise from better-than-expected earnings. Consensus earnings have been dropping of late on concerns about the global economy.

When you see the heavy investor concentration in utilities, staples, telecoms and health-care stocks that has taken place recently, he says, a good earnings season could make for a "pretty decent" upward move.

Indeed, one of the more interesting contradictions investors face is that the outlook from corporate executives seems downright enthusiastic compared with the market's gloom.

"The macro fundamentals have been overwhelming." says Lloyd Khaner, who runs Khaner Capital Management, "Yet company fundamentals are not that bad. The market has been anticipating that things will get worse and pricing things quickly."

It's not as if there's been a parade of third-quarter negative pre-announcements. Maybe investors will soon start to worry about the micro instead of the macro. That will seem like a relief.

THERE'S BEEN MUCH COMMENTARY about how U.S. stocks seem to be following the European sovereign-debt saga. With so many European government talking heads making almost daily comments, often contradictory ones, about how Greece's debt problem will be handled, it's no wonder investors are confused.

Investors know it's been a case of the tail wagging the dog. Historically, it's been the U.S. stock market that has led other world markets, but the extent of how closely the U.S. has followed Europe might come as a surprise.

The correlation seems extraordinary. While many S&P 500 companies get a big chunk of sales from Europe, you have to wonder if perhaps the U.S. broad market moves are exaggerated, given that it's the European banks that are likely to be the most exposed to this issue.

Through Friday, Sept. 30, the S&P 500 had declined just over 16% from 1353 on July 7. Most European stock markets close by 11:30 a.m. Eastern time, and the performance of stocks in the U.S. when Europe has been open versus when Continental markets were closed has been striking, according to Bespoke Investment Group.

The S&P has averaged a daily decline of 0.25% from the prior-day close until 11:30 a.m. since July 7, compared with an average decline of just 0.05% from 11:30 a.m. to the close.

Had you bought the S&P 500 index at the New York close every day since July 7 and sold the next morning at 11:30, you'd be down 13% at the end of the third quarter. Had you done the opposite—bought at 11:30 a.m. and sold at the 4 p.m. local close—you would be down just 3% over the same span.

Perhaps more interesting still is that the U.S. stock market seems to be taking its cue from the European bank stocks in particular, one of the worst-acting groups this year, according to International Strategy & Investment.

Nancy Lazar, a New York-based economist with ISI, notes that over the past three weeks there has been a 70% correlation between the Stoxx bank index, which has members like Deutsche Bank (DB) and Société Générale (SCGLF) and the S&P 500 index.

It's no longer a Greek problem, but a European bank crisis, which puts the global economy at risk, she adds.

OIL-SERVICE STOCKS are considered the quintessential "canary in a coal mine" group. Oil prices move, sometimes sharply, with economic-growth prospects, and oil-service stocks typically move in advance, often more quickly and with more-exaggerated rises and falls than the underlying commodity.

Oil prices are down by a third from 2011 highs, and oil-services shares are down 35% to 40%. They've been lashed on fears of another U.S. recession and slowing global growth. Such a denouement would push crude further to the downside. That, in turn, would reduce exploration budgets and make life difficult for the companies that actually do the drilling, pressure-pumping and down-hole work that bring oil and natural gas to the surface.

Right now, business looks "excellent for this group, but if oil prices drop to $60 to $70 per barrel, from the current $80, there will be an impact," says James Crandell, a veteran industry analyst at Dahlman Rose. Nevertheless, it appears the nearly 40% drop in the shares reflects "almost a probability of a double dip," says Crandell.

He's seconded in this view by Channing Smith, the co-manager of the Capital Advisors Growth fund. The stock market's been a binary bet for a while now—one day risk on, one day risk off, he notes.

But longer-term, oil and gas are necessary, and production growth at the oil majors remains their No. 1 concern, he says. Crude demand goes up and down in the short term, but in the long term, demand for energy and offshore oil rigs, for example, will grow, Smith adds.

If you are one of those investors who tries to time the market, don't bother with oil-service stocks. Where is the crude price going? We can confidently predict it will fluctuate. And this volatile sector has fallen more than 40% in past downdrafts.

At current levels, however, for a long-term investor who doesn't think that 2012's potential economic troubles mean the end of the world, this group is beginning to look interesting.

Schlumberger (SLB), whose stock is down about 33% from its 52-week high, to 62.64, has been and remains the group's leader. Using consensus estimates of $5.34 for 2012, the oil-service giant trades at 11.7 times, not much above a forward P/E low of 10 times in 2009.

Even a 50% drop in Schlumberger's EPS next year—which probably would require a pretty nasty recession—would put the valuation at around 23 times, below its 24 median over the past 15 years, according to Thomson Reuters.

A broader way to play the oil-service group is through exchange-traded funds, which avoid risks that might come with individual companies and their stocks. Among them are the SPDR Oil & Gas Equipment & Services ETF (XES) or the iShares Dow Jones US Oil Equipment & Services Index Fund (IEZ). (Dow Jones, a unit of News Corp., publishes Barron's.)

AS AN INDICATOR, the selling of a company's shares by insiders has a checkered pedigree when it comes to predicting the stock price. Insiders sell for lots of reasons—for example, because of tax issues as well as valuation.

Insider buying, however, tends to be more useful, as insiders who purchase their company's stock in the open market generally do so for one reason: They think the stock price is undervaluing what they know of the company's outlook.

On a broader level, insider buying is also useful as a potential valuation indicator of the market as a whole.

We checked in with Jonathan Moreland, director of research at InsiderInsights.com, and he says insider buying has indeed been increasing of late. However, he's not yet ready to suggest such buying is consistent with buying seen at past market bottoms.

As of Thursday, the rolling four-week average was 18%, meaning 18% more companies in the universe of all U.S. traded stocks have insiders buying their shares than selling. That sounds like a low number, but even though it was as high as 83% in early September, the fact that since early August it has continued to be positive is a good sign. And it is also the kind of buying, he adds, that was last seen in 2008-2009.

But before you go out and buy the market, he's at pains to note that the insider buying then began to grow significantly at equity levels much higher than the market bottom. Indeed, he compares this buying with that which began in the fall of 2008, long before the gut-wrenching bottom in March 2009.

If it's not the end of the downdraft, perhaps it's the beginning of the end.