Groupthink can be a dangerous phenomenon in the financial markets, but it can also provide an advantage in some circumstances. If we know what key price levels other traders are watching, and how they’re likely to react if and when those levels are reached, then we can plan accordingly.
Right now a lot of attention is being paid to a certain level in the S&P 500 that marks an alignment of various technical indicators. That level? 2118.
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The chart below shows the S&P 500 going back to October of last year. Notice the horizontal support/resistance line sitting right at 2118.
Last year the market rallied strongly from October through November, but then it stalled at this level and headed lower. The rough start to 2016 that we experienced also led to a massive rally, which again stalled in June right at this same mark.
From there we saw the creation of a minor reverse head-and-shoulders pattern, which had its neckline just a few points below the 2118 level. The rise above this neckline and subsequent breakout above 2118 led to a strong rally in the weeks following Brexit.
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More recently, price action turned negative and we saw the S&P correct back down to 2118, where that level became support for the market. We’ve since rallied, and currently, sit about 30 points above that mark.
Perhaps adding to the significance of that price is that it also represents a Fibonacci retracement level, as seen in the chart below.
The rally that began from the depths of the Brexit selloff topped out near 2190. The 61.8% retracement level consequently sits very close to 2118. Some consider this to be the most significant Fibonacci retracement level to watch as it represents the inverse of the golden ratio, 1.618 or phi.
The tough battleground that this price level has played over the last year makes it likely that many other investors are keying in on this level for clues on the direction of the market.
Since the market now sits above this key level of support, the path of least resistance is higher. But beware, a drop below that level could be met by significant selling pressure, which would take the market sharply lower in the short term.
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Moving on, let’s take a quick look at the outlook for corporate profits going into the end of the year.
So far, through Q2 of this year, we’ve seen earnings contract for five consecutive quarters (using Factset data). This doesn’t bode well for stocks and seems to conflict with the price action of the market, which has repeatedly hit new highs.
But there’s a silver lining here. Four out of the last five quarters would have seen positive earnings growth if the energy sector was stripped out. This makes the decline seem a little more benign, especially if you believe oil prices will remain range bound or perhaps head higher.
Up until recently, many analysts believed that the 3rd quarter was when companies in the S&P 500 would finally see earnings growth resume. That’s still possible, but becoming less likely.
As of Friday, Factset is predicting an earnings decline of 2.3% from Q3 of last year. Once again energy is expected to be the largest contributor to the decline, with earnings falling an expected 66%. For energy companies, it would mark the 8th consecutive quarter of earnings declines.
There is some possible good news lurking beneath the surface, however. Revenues, which haven’t increased since the end of 2014, are actually expected to see growth in the 3rd quarter. Currently, 9 of the 11 S&P sectors are expected to report year-over-year sales growth.
The other piece of possibly good news is that analysts have a habit of underestimating earnings. According to Factset, actual earnings growth for the S&P 500 comes in on average 2.8% higher than estimates.
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With the Q3 earnings decline pegged at 2.3%, an “average” beat by S&P 500 companies could actually put Q3 earnings in the green.
Altogether these figures may support the market going forward. Revenues, unlike earnings, which can easily be manipulated, are viewed as a sign of aggregate demand. If revenues do come in higher for the first time in almost two years, it will be a good sign for the overall economy.
And if we can eke out a sliver of earnings growth too, it will finally help support P/E ratios, and could allow for the market to move higher without further multiple expansion.
Only time will tell; we’ll begin to get an idea of Q3 performance when earnings season gets underway in a couple of weeks.
The preceding content was an excerpt from Dow Theory Letters. To receive their daily updates and research, click here to subscribe.
