Can the laggards now leading the market keep winning?
Given the latest chilling economic news from China, this time about a tumble in imports, it wouldn't be surprising to see Wall Street pull back from its recent hefty gains on Tuesday. Sparking the October rally has been rising odds the Federal Reserve won't raise interest rates this year in the face of ho-hum economic data and still-low inflation.
One sign of shifting sentiment is the CBOE Volatility Index (VIX) -- known as Wall Street's "fear gauge" -- which had dropped for 10 days in a row through Monday for a loss of nearly 42 percent. Another measure can be seen in sectors that have been leading the charge higher: areas like materials, industrials, energy and emerging market stocks, all of which had been lagging since May on fears over low commodity prices, China's weakness and the impact of a strong U.S. dollar.
The question: Is the rebound in these areas sustainable -- or is it a trap for the bulls?
And can it continue as the third-quarter earning season gets busier this week when 20 percent of the S&P 500 releases results? According to Factset, third-quarter earnings for the S&P 500 are expected to decline 5.5 percent in what could be the first back-to-back earnings drop since 2009. Already, 76 S&P 500 companies have issued negative earnings per share guidance vs. 32 issuing positive guidance.
Negative expectations are focused on energy and materials stocks. On a year-over-year basis, energy stocks in the S&P 500 are expected to suffer a 62 percent decline in earnings, while material components are expected to show a 12.4 percent drop.
The team at Bank of America Merrill Lynch led by Savita Subramanian believes actual results won't be as bad as analysts currently forecast, thanks to a relatively flat U.S. dollar during the third quarter. They see overall results coming in roughly unchanged over the year-ago period -- which would be a positive surprise.
Moreover, according to an analysis by the Bespoke Investment Group, when expectations for earnings season are as bad as they are now, stocks in sectors like industrials are poised to benefit the most from better-than-expected quarterly numbers.
Things look good for the overall market as well, according to Bespoke.
Its analysts base this on the history of market gains in relation to the gap between companies with negative analyst earnings revisions vs. those with positive revisions. When it's negative, like now, the S&P 500 finished with an average gain of 2.3 percent six weeks later vs. an average loss of 1.2 percent when expectations were high and revisions were positive.
Taken one step further, the spread between negative and positive revisions is quite large currently at -24 percent -- a depth only seen four other times during this bull market. During those four other times, stocks rallied an average of 4.4 percent each time.
All of this suggests that a combination of no 2015 rate hike from the Fed and a possible light at the end of the tunnel for energy, material and industrial sector earnings could result in additional stock price gains in these areas.
Still, some on Wall Street are skeptical that the recent market laggards can keep leading.
Goldman Sachs analysts note that the relative strength reversal (laggards to leaders, and leaders to laggards) has been so extreme that it has happened to this extent just one percent of the time since 1980. While they admit that the status quo ante is rarely restored when something like this happens, they worry about the impact of debt ceiling negotiations, a possible surprise hike from the Fed in December and the still real chance that third-quarter earnings are as bad as feared.
Deutsche Bank strategist David Bianco wrote on Monday that the rise in energy and industrial stocks has been premature because these areas are still vulnerable to risks from an underperforming global economy.
And any more bad news out of China could put the new leaders back to the bottom again.
