Expect Earnings-Related Volatility To Increase

With the onset of another earnings season, it’s normal to expect increased turbulence in the equity market as investors react to corporate profit hits and misses. The latest reporting season is likely to see even more volatility than normal, however, for reasons I’ll explain in today’s commentary. While I expect the stock market’s underlying bullish trend to remain intact, I’ll make the case that investors should prepare for a choppy trading environment in the weeks immediately ahead.

Wall Street’s attention was drawn to the transportation industry this week as the latest earnings season gets underway. Proponents of the Dow Theory are especially concerned by the lagging nature of the Dow Jones Transportation Average (DJTA). Specifically, Dow Theory states that a failure of the Dow Transports to confirm the Dow Jones Industrial Average (DJIA) is potentially bearish, and that the failure of the DJTA to confirm the recent high in the DJIA is sending a negative message for the broad market outlook. While I don’t agree with this interpretation, for reasons we’ll discuss here, the recent action in several leading railroad stocks is somewhat of a concern for the immediate-term (1-4 week) outlook. It suggests that there will be greater volatility in the weeks ahead, though I don’t believe it will compromise the uptrend in the major averages.

Several leading rail stocks saw big declines this week, with the shares of CSX Corp. (CSX) dropping over 10% on Jul. 17 in response to a missed earnings estimate and revenue decline. Other U.S. railroad stocks were equally hard hit on that day, including Union Pacific (UNP), which lost 6.1%, and Norfolk Southern (NSC), whose share price dropped by 7.5%. The spillover impact of the railroad stocks caused the Dow Jones Transportation Average (DJTA) to drop 3.6% on Jul. 17, and investors are now worried that earnings season will bring more misses than beats.

CSX Corp

Source: BigCharts

CSX was by far the biggest negative influence on the transports, but earnings warnings from trucking companies Knight-Swift (KNX) and Covenant Transport (CVTI) also contributed to the negative sentiment. Interestingly, the transports were among the best performers among the major industries in recent days amid easing concerns about a downturn in the sector. The latest round of earnings reports and guidance quickly caused analysts to change their tune.

While this industry will likely contribute to the short-term volatility increase I’m expecting, the overall transport outlook isn’t a serious concern for the health of the bull market. The Dow Transportation Average isn’t far below the year-ago high and is closer to its September 2018 high than its December low. Transportation stocks, moreover, aren’t showing up on the list of 52-week lows for either the NYSE or the Nasdaq. This suggests that no liquidation is taking place among the leading stocks within the industry. Only when we start seeing transportation stocks making new 52-week lows should there be a genuine concern for the industry’s intermediate-term (3-6 month) outlook.

Not all the latest earnings news has been bad, either. The banking industry stocks, which have an outsize importance for the overall S&P 500 outlook, have recently gained on earnings-related results. The most recent winners include Bank of America (BAC) and U.S. Bancorp (USB), shown below. Clearly, the rising short-term internal momentum for the bank stocks as discussed in previous reports has helped relative strength stocks like USB push higher in a market which is increasingly vulnerable to disappointing earnings results.

U.S. Bankcorp

Source: BigCharts

Shown below is the 4-week rate of change for the new highs and lows among the most actively traded U.S.-listed bank stocks, mentioned previously. The rising trend in this indicator suggests that the near-term path of least resistance for the bank shares in general is to the upside. This indicator shows that the incremental demand for bank stocks has been on the upswing in recent months. That’s an encouraging sign as we enter another potentially volatile earnings season. If informed investors were bearish on the broad market outlook, it would almost certainly show up first in the bank stocks in the form of selling pressure. This clearly isn’t the case, though.

Source: NYSE

Although the financial sector is holding its own, it’s not exactly setting the investment world on fire. The reason for that is obvious. Treasury yields remain weak and this is pressuring banks’ net interest margin. Rising rates generally bolster bank earnings, and the decline in the CBOE 10-Year Treasury Note Yield Index (TNX) of the last few months has put some pressure on the bank stocks. Shown below is the TNX chart, which remains near its low for the year. A rally in the 10-year yield would definitely help stimulate some additional strength in the leading blue chip banking shares. For now, though, low bond yields are keeping the bank stocks from experiencing a more vigorous rally. The downward trend in Treasury yields will also likely keep the PHLX/KBW Bank Index Index (BKX) in its well-established lateral trading range for at least a few more weeks.

CBOE 10-Year Treasury Note Yield Index

Source: BigCharts

One of the most important charts that traders should be watching in the days and weeks ahead is the CBOE Volatility Index (VIX). Normally I don’t advise paying much attention to this gauge of broad market volatility since it’s short-term signals are mostly meaningless noise. As we’re about to enter the heart of earnings season, however, volatility is likely to increase if only due to several upcoming earnings surprises among some market-moving companies. It’s therefore incumbent that we pay closer attention to VIX due to the obvious implications of earnings surprises on the major indices.

Shown below is the VIX daily graph in relation to its 15-day moving average. You’ll notice that VIX has been unable to generate a 2-day higher close above its 15-day MA since May. This was the last time there was any meaningful volatility in the broad market, and since then volatility has substantially subsided. It’s more than likely, however, that we’ll witness a pickup in the level of turbulence in the market in the coming weeks as earnings continue to pour in. So let’s be prepared for some periodically brief periods of choppy trading conditions ahead. A 2-day higher close above the 15-day MA in the VIX would technically confirm that volatility is once again on the upswing.

CBOE Volatility Index

Source: BigCharts

Meanwhile, internal conditions on the NYSE and NASDAQ remain bullish, both on a short-term and on an intermediate-term (3-6 month) basis. The 4-week rate of change (momentum) in the NYSE new 52-week highs and lows remain in a rising trend, as can be seen below. As I’ve emphasized in past reports, as long as this indicator is in a rising trend the path of least resistance for stock prices in the aggregate is still up. The 4-week rate of change is beginning to slow, however, as the following graph shows. But as long as the overall trend in the new 52-week highs and lows remains up it will support a buoyant outlook for the broad market in the near term.

Source: BarChart

In recent days, however, there has been an uncomfortable increase in the number of NYSE and NASDAQ shares making new 52-week lows. On July 18, for instance, there were just over 90 stocks making new lows on the Big Board. Most of the stocks making new lows lately have been in one of the following major industries: pharmaceutical/biotech, energy, or consumer retail.

The most persistent of the industry groups showing up on the new lows list in the last several weeks has been the pharmaceutical/biotech stocks. This isn’t necessarily a threat to the overall health of the broad market, for I don’t consider the participation of this industry group as being critical to a strong and healthy bull market. However, as long as there are more than 40 stocks making new 52-week lows on the NYSE for more than a few consecutive days, it will be reason enough increase our defenses. Right now there hasn’t been enough of a danger signal to do so, but if we see a few more days of above-normal new 52-week lows it will be time to pull in the horns a bit by raising some cash, culling the laggards from portfolios, while taking some profits among the winners.

Speaking of pulling in the horns, although retail investors still haven’t capitulated to the bull market by embracing a bullish posture, there has been an increase in the percentage of investors who describe themselves as bulls. In the latest sentiment survey by the American Association of Individual Investors (AAII), 36% of members identified as bullish. That’s a 2.3% increase from last week, but still below the historical average of 38.5%. It’s also well under the 50% bullish level which is typically seen at major stock market peaks.

AAII Investor Sentiment SurveySource: AAII

Meanwhile the AAII bears were 28.6% in the latest week, an increase of 1.1%. That’s still a below-average percentage of bears, but the overall implication of the AAII sentiment survey is that investors are mainly neutral on the intermediate-term broad market outlook. Nearly every major bull market in history has concluded with a blow-off rally immediately prior to the bull’s death. With neutrality the dominant investment stance right now it suggests that investors haven’t over-committed to equities and still have plenty of cash on the sidelines that can be deployed before the final run-up to new highs begins.

While retail investors aren’t fully committed to the bull market – which implies the bull still has further to run before expiring – there’s also a signal from corporate insiders which suggests that there will definitely be at least a few big earnings-related hits among individual companies this reporting season. The Thomson Reuters Insider Transactions Ratio rose from a multi-month low of 7 last month to a 1-year high of 55 as of last week. That’s an incredibly high reading for this measure of insider selling, and it means that many corporate insiders have been selling shares of their own companies for a variety of reasons.

Source: Thomson Reuters

While this signal alone can’t be considered as a bearish broad market indicator, it’s nonetheless a “heads-up” that earnings-related volatility is almost certain to increase in the next couple of weeks. In other words, it’s time once again to walk slowly as we enter the always unsteady ground of another earnings season. That means tightening up stop losses on existing long positions and refraining from initiating any new trading positions until the insider transactions ratio shows decided improvement.

In conclusion, the indicators discussed in this report suggest that volatility will increase in the coming weeks as corporate earnings provide an unstable backdrop for many areas of the broad market. Short-term instability within the transportation industry will likely be a big contributor to this volatility. Banks stocks, by contrast, are poised to benefit from the latest reporting season. In the overall picture, the data we’ve been discussing in this report also supports the bull market surviving yet another earnings season intact. While there will undoubtedly be signs of weakness in some industries in the coming weeks, the persistent strength, scope and breadth of NYSE-listed stocks making new 52-week highs suggests that there will also be many upside surprises as well. In view of the positive weight of evidence, investors are justified in maintaining a bullish intermediate-term posture toward equities.

On a strategic note, I’m currently long the Invesco Dynamic Semiconductor ETF (PSI), which tracks several stocks in the broad semiconductor industry. I’m using a level slightly under the $53.00 level as my stop loss on this trading position. I’m also currently long the iShares Core Growth Allocation ETF (AOR). AOR seeks to track the investment results of an index composed of a portfolio of underlying equity and fixed income funds intended to represent a growth allocation target risk strategy. The fund’s holdings include U.S. Treasury, agency and corporate bonds, as well as U.S. stock funds and equity funds which track emerging and developed markets outside the U.S. I’m currently using a stop-loss slightly under the $45.00 level (intraday basis) for this trading position.

Disclosure: I am/we are long AOR, PSI. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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