After the biggest five-day rally of the year for stocks, the bulls cooled their heels a little on Tuesday. But with sentiment still bombed out, it's possible that even a modest upside surprise in the coming third-quarter earnings season could fuel a relief rally throughout October.
According to Yardeni Research, the Investor Intelligence Bull/Bear Ratio fell to its lowest level since March 2009 and has been depressed for the last five weeks. Jason Goepfert at SentimenTrader finds, after compensating for the recent market decline's influence on sentiment, investor pessimism has reached an extreme rarely seen in the last 30 years.
To be sure, investors have a lot to worry about.
On the economic front, the International Monetary Fund cuts its 2015 and 2016 global growth expectations from 3.3 percent and 3.8 percent, respectively, to 3.1 percent and 3.6 percent, respectively, on a worsening outlook for emerging markets. It cited the threat of further economic weakness in China risking a "hard landing" scenario.
The U.S. trade balance is already feeling the pressure from these dynamics, with the trade deficit rising 15.6 percent to $48.3 billion in September. Exports fell 2 percent to their lowest level since October 2012.
Globally, JPMorgan's manufacturing activity index has dropped to its lowest level since July 2013 -- an indicator that, according to Yardeni, has a close correlation with S&P 500 revenues.
No wonder all eyes are now turning to the start of the third-quarter reporting season. Factset is predicting S&P 500 earnings will fall 4.5 percent over last year's quarter -- potentially the first back-to-back quarterly earnings decline since 2009. Weakness is once again being blamed on low commodity prices, problems in China and the drag from a strong dollar.
Investors are paying close attention.
After the close Tuesday, both Yum Brands (YUM) and Adobe (ADBE) were hit hard, down 16 percent and 4 percent, respectively in after-hours trading. Yum reported weaker-than-expected earnings and revenue, cut its forward guidance and warned that its key China sales were slowing. Adobe cut its fiscal 2016 guidance.
But there's hope. Analysts were similarly pessimistic heading into the first- and second-quarter reporting seasons as well, but companies were able to surprise with earnings growth of 1.5 percent in first quarter and a flat result for the second. An upside repeat is possible.
Moreover, 2016 is looking a lot better, with S&P 500 earnings now projected to grow 10.3 percent. As a result, Yardeni is looking for the S&P 500 to rise to 2,300 by year-end 2016 (that would be a 16 percent increase). He believes earnings will rise an average of nearly 9 percent annually over the next two years.
If anything will boost investor sentiment, it's a reacceleration of earnings growth in this tough environment.