Look to Earnings for Markets’ Direction

Stocks are up 30% over the past year, despite higher long term Treasury yields and earnings growth that averaged around 5% in the latest period. Skeptics point toward the impact of the Federal Reserve’s third round of quantitative easing for the rally, and now that the program is being wound down -- though it’s anyone’s guess how quickly -- stocks could face some headwinds.

Bulls, on the other hand, believe that with the economy strengthening, earnings growth will accelerate and stocks should be able to rally further even with reduced support from the Fed.  Earnings season is already just beginning, and management commentary on the state of their markets and consumer demand will be just as important as whether numbers beat on the top and bottom lines.

To see if the “bull thesis” holds water, you should look to these names when they report earnings for some idea of where the markets may be headed in the next several months.

General Electric (NYSE:GE) - January 17th: After spending a few years in the wilderness, GE is relevant again. Its broad portfolio of businesses, ranging from health to locomotive engines, and global presence, will offer strong clues as to whether we are truly seeing economies around the world accelerate. Expectations are for EPS of $0.53 vs. $0.44 in the prior year, but perhaps more important than the bottom line numbers will be GE’s reported order trends in its Transportation, Aviation, Power & Water and Oil & Gas segments. GE also breaks out its orders for its “growth market” segments, and I would look there for a feel on how healthy emerging markets are at the moment, and how healthy they are likely to be going forward.

Those bullish on the stock market are quick to say industrials will benefit from better growth, so in addition to GE, I will be paying close results to companies such as 3M (NYSE:MMM), likely to report toward the end of January. 3M was up 50% last year, an incredible gain for a company of its size, so earnings reports will be critical for further gains.

Other industrial companies important to the market will be diversified manufacturers Illinois Tool Works (NYSE:ITW) and Danaher (NYSE:DHR), both scheduled to report on January 28th. If industrial stocks can give solid results and positive guidance on the whole, it will bode well for the overall equity markets.

Banks are another segment bulls look for more rapid growth from in 2014 and beyond, as loan growth increases with the economy -- and hopefully interest margins expand as the Fed moves away from QE.

One company I will be looking at is Bank of America (NYSE:BAC) - January 15th --  The shares are up 44% since the start of last year, and the bank needs earnings growth to justify its high-flying stock price, with the stock trading comfortably above tangible book value of $13.62 per share. Expectations are for a solid quarter of $0.26 versus just $0.22 a year ago when unusual items are excluded. Interest margins will likely remain depressed this quarter, keeping the company’s return on equity well under 10%.

However, earnings gains could come from loan growth, which I think will be important as the market assesses the quality of BAC’s earnings. In addition, look for gains in the company’s Global Wealth and Investment Management segment, given the strong stock market in the fourth quarter of last year. Finally, credit costs will remain muted, and look for more releases of credit reserves the company accrued during the financial crisis. While reserve releases are not the best quality of earnings, they have supported results while interest margins remain depressed. Reserve releases did account for approximately $0.07 of the $0.20 the company earned in the third quarter of 2013, and any decline in this contribution would be welcomed by the market.

Finally, I think Internet and social-media stocks have become a very important, perhaps the most important, segment of the technology sector. The companies are growing rapidly, but their valuations on several metrics, alongside questions surrounding sustainable growth, makes the group controversial.

Still, strong results from Google (NASDAQ:GOOG), Amazon.com (NASDAQ:AMZN) and Facebook (NASDAQ:FB) helped drive the market rally in the last quarter of 2013. Interestingly, these three companies are among the six companies with market capitalization of over $100 billion that have PEs over 20 (Visa (NYSE:V), MasterCard (NYSE:MA) and Gilead Sciences (NASDAQ:GILD) are the others), underscoring their place as market favorites.

Let’s take a close look at Google, which is the largest of these companies with a total market capitalization of $377 billion, it is the third largest company in terms of market capitalization, bested only by Apple (NASDAQ:AAPL) and ExxonMobil (NYSE:XOM). Earnings expectations are for EPS of $12.24 vs. $10.59 when the company reports on Jan. 30th.  Google’s stock has soared from $888 prior to its report of third quarter earnings. While the company only had a modest EPS beat ($10.74 vs $10.34, less than 4% above expectations), the quarter did serve as a bit of affirmation for GOOG’s continued growth. So I think the market is counting on another quarter from GOOG, and I think a shortfall here could have implications for other Internet-based companies as well, given their recent strong run.

In fact, given that the market looks at these stocks as one of the few areas proving growth in an otherwise lackluster earnings environment, I think across the board weakness in these mega-cap Internet names, should it occur, will pressure the entire market.

The upcoming earnings season is a critical one, and I think the company outlines above will be real market movers. While there are other factors that will influence the market as well, all things being equal, good results from these names should lead to a firmer market through the first quarter of 2014. Likewise, disappointments could pave the way for a 5% to 10% correction.

Hilary Kramer is the editor-in-chief of the subscription newsletters: Game Changers, Breakout Stocks Under $10, High Octane Trader, Absolute Capital Return Portfolio and Inner Circle. Formerly, Hilary was the CIO of a $5 billion global private equity fund. She has an MBA from the Wharton School at the University of Pennsylvania and began her Wall Street career as an analyst at Morgan Stanley. Hilary is the author of The Little Book of Big Profits from Small Stocks (Wiley) and Ahead of the Curve: Nine Simple Ways to Create Wealth by Spotting Stock Trends (Free Press). To learn more about Hilary Kramer visit: http://GameChangerStocks.com.