Will Sector Rotation and Earnings Reports Preserve the Bull Market?

Earnings season got off to a fine start last week with Intel (INTC) and JPMorgan Chase (JPM) filing reports that beat The Street in all metrics. But earnings season is heavily slanted toward financials early on and the balance of reports out of the banking sector were disappointing. Even Goldman Sachs (GS), which on the surface filed an attractive report, missed their whisper number and didn’t shed a lot of light on their real estate vulnerabilities.

The result was ugly selling in the financials on Friday. The sector is far from breaking down technically but does not appear poised to continue to lead. This is important because financials were THE early leadership in the bull market, even though there are precious few quality plays in the sector. Going forward they don’t have to lead but they must hold up. And other sectors must step up to assume the mantle of leadership. Otherwise the market could prove vulnerable.

Fortunately we’ve seen rotation into energy stocks, which now dominate the new highs list. Indeed on Friday oil broke out to new recovery highs from a well formed base. This is the latest sign of an overall rotation into commodities. Precious metals began a similar break out move in early September.

These moves are being driven by a witch’s brew of factors, not all of them healthy for the economy or the market in the long run. On the positive side are continued signs of a global recovery. But on the negative is the dollar, ever weaker due to Fed policy thus driving the dollar denominated price of commodities higher. These moves in commodity prices hint at nascent inflation and have the potential to haunt the market if they continue too strongly.

This rotation has been reflected in international leadership. The Shanghai Composite led the worldwide stock market from March into August but it has been correcting since. The correction has been significant, about 23% at its maximum depth, but is showing tentative signs of ending. But even as Shanghai paused to consolidate its massive gains commodity based economies have seen their stock markets take up the yoke of leadership, with Brazil and Russia moving smartly higher since early September. Russia is a small and less significant market. But Brazil is an emerging commodity power and its market is more significant to our analysis. It is up about 20% in that time and better than 75% for the year.

While the market has the technical wherewithal to hold up much will depend on earnings this week. INTC has hinted at a strong refresh cycle in computers and the market will want to see further evidence of that from Apple (AAPL), which reports after the bell today, and Microsoft (MSFT). Beyond that the market will want to see a better performance than reported by the banks last week. In addition to “better than expected” earnings reports it will demand expanding top lines and optimistic guidance to reinforce the recovery paradigm that has driven it higher since March.