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These under the radar problems may derail the stock market's impressive rally

Brian Sozzi
Editor-at-Large

First quarter earnings season may seem as if it is trekking along just fine and dandy, but underneath the glamorous beats of Wall Street’s tempered profit estimates lays a problem.

Actually, make that two problems — both of which call into question the absurd levels of bullishness that has spread through markets this year.

You have been warned, bulls.

Good news is overshadowing the bad

So far, so good has been the theme in the early innings of the four times a year storm known as earnings season.

Over two-thirds of the financials in the S&P 500 have reported earnings, and they have beaten estimates by 4% in aggregate according to Bank of America Merrill Lynch. Hat tip to the likes of JPMorgan Chase and Citigroup for leading the charge among the financials.

In total, earnings by the 25% of the S&P 500 that has reported have eclipsed profit estimates by a solid 3%. Companies from PepsiCo to Kimberly-Clark to Whirlpool have joined the banks in nicely surprising Wall Street to the upside on the profit front.

But the headline beats of some are overshadowing two negative developments.

First, profit beats aren’t getting as much love by traders compared to historical norms. Companies that have beaten on sales and profits have outperformed the S&P 500 by 1.2% on average the next day, worse than the 1.6% long-term average as compiled by BofA strategists. Those firms that have missed on both key line items have seen their shares lag the S&P 500 by 3% the next day, worse than the 2.4% historical average.

The action suggests that at least near-term, stock valuations could be fairly full.

Meanwhile, conference calls held by corporate chieftains haven’t been too upbeat, either. BofA says conference call commentary “continues to suggest slowing trends.” Mentions by execs of “better” or “stronger” business conditions versus “worse” or “weaker” are tracking the lowest since the the first quarter of 2016, BofA says. The investment bank adds optimism among execs has “waned.”

Executives may be simply playing it safe into the second quarter amid the ongoing U.S. trade war with China and slowing domestic job growth. But their ho-hum commentary thus far isn’t exactly the lighter fluid that will ignite the next leg to the equity rally.

Too early to tell

While it’s still early in the reporting season, data such as this deserve careful attention by investors in the weeks ahead given how fast valuations have expanded from the December 2018 lows. If the negative data persists, the market could move to readjust valuations on a litany of red-hot sectors — chief among them FAANG stocks, which have been on an insane run this year.

Why pay top dollar for stocks when the second quarter hasn’t started as strong (see conference call commentary) and the market isn’t rewarding — to the fullest extent possible — earnings beats, right?

Yes, right.

Brian Sozzi is an editor-at-large at Yahoo Finance. Follow him on Twitter @BrianSozzi

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