Extreme greed in the stock market is producing a bad setup as earnings season starts

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Earnings are the single best guide in the stock market in the long term.

In the short term, sentiment rules.

Only 8% of the strong move up in the stock market last year was attributable to earnings. The rest was triggered by the Federal Reserve reversing its policy of raising interest rates, which boosted sentiment, especially among the momo (momentum) crowd.

In short, sentiment is driven by fear and greed. The CNN Fear & Greed Index stands at 90, representing extreme greed. Our proprietary sentiment indicator at The Arora Report differs from CNN’s conclusion in that the stock market is not yet at an extreme bullish level; it is approaching the extreme zone.

Earnings season is starting. And this level of greed is producing a bad setup. Let’s explore the issue with the help of a chart.

Read: Why the Dow’s top 20 years ago is a warning for stock investors today

Chart

Please click here for an annotated chart of Five Below FIVE, +5.55%.

Note the following:

• Five Below is a high-flying retailer that is considered Amazon-proof.

• For a retailer, the stock is very expensive, trading at a trailing price-to-earnings (P/E) ratio of 39.

• The chart shows that the stock gapped down 14% after the company reported poor earnings. On Tuesday morning the stock rebounded, rising over 4% as of this writing.

• In a normal market environment, an expensive retail stock like Five Below would have continued to fall after the gap down at the open.

• Similar behavior happened in Abiomed ABMD, +2.05%, a medical-device company, after it reported poor earnings.

• Delta Air Lines DAL, +3.53%  reported earnings that were better than the whisper numbers. But that is a special case because the airline is benefiting from the trouble of other airlines related to Boeing BA, +0.38%.

• Among banks, J.P. Morgan JPM, +1.98% and Citigroup C, +1.98% reported good earnings, and Wells Fargo WFC, -4.06%  reported weak earnings.

• The vast majority of earnings are still ahead.

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Bad setup for earnings

Stocks move based on the difference between the whisper numbers and the actually reported earnings, as well as projections. The whisper numbers are different from the published consensus numbers. As the stock market has risen, the whisper numbers continue to go higher. At The Arora Report we monitor economic data from 23 countries.

Looking at economic data and the history of earnings, there is a high probability that overall earnings this season will disappoint.

Should you sell?

Five stocks carry an extraordinary weight in popular indexes such as the S&P 500 Index SPX, -0.19%, which is represented by S&P 500 ETF SPY, -0.17%. The five are Amazon AMZN, -1.30%, Apple AAPL, -0.57%, Facebook FB, -0.73%, Google parent company Alphabet GOOG, -0.28% GOOGL, -0.32% and Microsoft MSFT, -0.17%. Apple and Microsoft are also in Dow Jones Industrial Average DJIA, +0.10%.

It is conceivable that in the short term, stock market investors may focus only on the earnings of those five stocks, plus semiconductor stocks, while ignoring other earnings.

Among semiconductor stocks, the ones to watch are Intel INTC, -0.58%, AMD AMD, -1.18%, Micron Technology MU, -1.51% and Nvidia NVDA, -1.77%. Research firm Gartner says worldwide semiconductor revenue totaled $418.3 billion in 2019, down 11.9% from 2018. However, semiconductor stocks have had one of the best runs in the hopes of a great 2020. Unfortunately, the leading economic indicators do not support the market’s conclusion.

A poor earnings setup is not a red light; it is a yellow light. It is important for investors to stay extra alert during this earnings season. We will be paying special attention to our proprietary sentiment indicator to give us actionable signals.

Also keep a close eye on segmented money flows for early indications. For background, please see “Something rare is happening among popular technology stocks” and “10 things stock market investors ought to watch out for in January.”

Disclosure: Subscribers to The Arora Report may have positions in the securities mentioned in this article or may take positions at any time. Nigam Arora is an investor, engineer and nuclear physicist by background who has founded two Inc. 500 fastest-growing companies. He is the founder of The Arora Report, which publishes four newsletters. Nigam can be reached at Nigam@TheAroraReport.com.

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