A conflicted stock market faces moment of truth as earnings loom

After being stuck in a state of suspended animation for the past few weeks, the stock market will finally have its moment of truth as corporate earnings begin rolling out over the next few days.

There will be a lot riding on this earnings cycle. It will be the first quarter since President Donald Trump took office, providing a look at whether the euphoria that propelled major stock indexes to historic levels was justified. It could also be the spark that rejuvenates the market as investors have become increasingly cautious amid signs that many of the pro-growth policies promised by the new president may be delayed.

On Friday, the Dow Jones Industrial Average

DJIA, -0.03%

 fell 6.85 points to end at 20,656.10, closing flat for the week. The SP 500

SPX, -0.08%

 shed 1.95 points to finish at 2,355.54, falling 0.3% for the week and the Nasdaq Composite Index slipped 1.14 points to 5,877.81, logging a weekly decline of 0.6%.

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J.P. Morgan Chase Co.

JPM, -0.35%

Citigroup Inc.

C, -0.77%

and Wells Fargo Co.

WFC, -0.96%

will be among the first to report quarterly results. The financial sector has been in the spotlight since the Federal Reserve’s shift to a tighter monetary policy regime, and first-quarter results will be a critical test for whether bank shares have more upside potential.

Across the board, earnings are expected to rise as much as 12%, which will mark the highest growth in profitability since third quarter 2011, according to John Butters, senior earnings analyst at FactSet.

However, there is always a chance that earnings may fall short.

“What I do see as a possibility is early first-quarter earnings perhaps not living up to the expectations and that increases the selling pressure and the market uses that as a reason to sell off but I’m thinking if this does occur then we only see the selling mounting to down 5%-7%,” said Bob Pavlik, chief market strategist at Boston Private Wealth.

There is also the risk that if earnings fail to revive the market’s momentum, investors may be forced to play an extended waiting game for the next catalyst.

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As Jeffrey Saut, chief investment strategist at Raymond James, noted, the SP 500 has been corralled between 2,335 to 2,400 for the past couple of months, which he blames on the market being “confused” with no clear indication whether it is headed up or down.

“The best strategy has been to basically do nothing,” said Saut.

Jason Goepfert, president of Sundial Capital Research, pointed out that there is “a large conflict between bullish and bearish inputs.”

Perhaps the confusion shouldn’t come as a surprise, given that for each incentive to buy stocks, there are just many reasons to sell. It may also be symptomatic of the uncertain times as President Trump’s policies get bogged down by politics.

“If you are still of the belief we can get tax reform done in a meaningful bi-partisan way, then there is room to go on the upside because I think the market is pricing in only a 65/35 chance it does at this point. By meaningful I mean less than 25% corporate tax rate with a one time repatriation holiday at 10% and a cut in individual taxes ideally without a border-adjusted tax,” said Ian Winer, head of equities at Wedbush Securities.

On the other hand, there is a strong case to sell stocks since tax reforms could fail given the difficulties over repealing and replacing Obamacare and tax cuts are not possible without a BAT, he said.

Similar arguments apply to the economy.

See also: Trump economy starting to look like the same-old, same-old

“You buy if you think we can get to 3% to 3.5% GDP exiting 2018. You sell if you think the economy is not going to improve,” he said. “If we can’t grow above 2% to 2.5% then our upside is limited from here.”

To make matters more murky for investors, even the charts are sending garbled messages.

According to Goepfert, the NYSE Advance/Decline Line is climbing even while the SP 500 is moving lower. The rise in the Advance/Decline Line, which tracks the number of advancing stocks minus the declining shares each day and adds that to the figure from the previous session, indicates a positive trend.

Sundial Capital Research

“The only times the SP showed a loss over the prior month while the A/D Line rose at least 1% and hit a multiyear high during the month were in April 2014 and April 2016. Both led to nice rallies over the next few months,” he said in a report.

However, Chris Kimble, founder and chief executive of Kimble Charting Solutions, had a different take on the market.

Kimble believes the Dow Jones Transportation Average

DJT, -0.32%

a bellwether for the U.S. economy, may be forming a bearish pattern similar to the ones observed in 1998-99 and 2007-08.

“The bulls will need the transports to blow through the red resistance line to breathe a sigh of relief. If not, it could spell trouble for the transports,” he wrote in a blog post.

Kimble Charting Solutions

In his chart, he pinpointed 9,109 as a key support level.

“A break below this line would be the first warning to investors,” he said.

The index closed at 9,104.81 on Friday.

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