The Coming Week: Feared Wave of Warnings Threatens to Soak Rally

Earnings forecasts are still dreary, and company guidance won't be sheltered by economic data.
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Unless it's curtains for Osama bin Laden over the weekend,fears that the autumn rally got ahead of itself probably will dominate trading on Wall Street again in thecoming week.

A mild decline started the first week of Decemberand deepened last Thursday, when earnings warnings from

Ciena

(CIEN) - Get Report

,

Lucent

(LU)

and

Qwest

(Q)

, as well as a weak

retailsales report, spurred a more dramatic selloff.

"The news flow has turned decidedly more cautious,"says TobiasLevkovich, senior institutional U.S. equity marketstrategist at Salomon Smith Barney. "We may have moved abit too far too fast, and nowfundamentals aren't supporting that."

A couple of

Dow

components --

Merck

(MRK) - Get Report

and

American Express

(AXP) - Get Report

-- also revised their guidance downwardlast week, while several companies announced

fresh job cuts.

A Tangled Web

Still, stocks ticked higher Friday after hoveringaround the flat line for much of the session. Marketwatchers attributed the slight move higher to rumorsthat bin Laden had been found. American-backed troops inAfghanistan believe they have the terrorist leader andhis key fighters surrounded in a complex of cavesoutside of Tora Bora, although U.S. officials acknowledgedthey still do not know bin Laden's exact location.

No matter what the tone of the market next week,year-end portfolioshuffling probably will distort stocks' moves. Ifportfolio managers are cleaning up their portfolios forpresentation to investors by buying winners and sellinglosers, their moves could give a boost to the year'sstrongest stocks. Tax-loss selling, or selling yourlosers to offset profits and capital gains taxes on anywinners, could, conversely, exacerbate any losses.

"It's a crazy time of the year," says Larry Rice,chief investmentstrategist at Josephthal, a privately held New Yorksecurities firm. "Tax-loss selling and year-endportfolio readjustments add to the volatility. A lot ofthe stocks that held up really well get stuck inportfolios, while losers get sold for tax purposes."Although others have predicted any pullback will retracejust one-third of the market's rally, Rice ultimatelyexpects a pullback to erase 50%.

'Fessing Up

The indices remain above key support levels --pegged at 1700 on the

Nasdaq

and 9700 on the Dow. Recentlosses remain meager compared with this fall's gains.The Nasdaq is off 4.9% over the past seven sessionsvs. a 40% gain since Sept. 21. The Dow and

S&P 500

,meanwhile, each of which raked in gains of more than 20% inthe big run, have lost 3% and 1.9%, respectively, sinceDec. 5.

Nonetheless, the recent slide could be significant.Some strategists have been predicting a pullback forweeks, and there's no ignoring the timing. Fourth-quarter earnings warnings began to roll in last week,and the past three warnings seasons have rocked stocksout of rally mode and into decline.

Further stock market gains will have to be driven byevidence ofeconomic and earnings recovery rather than expectations,says Barry Hyman, chief investment strategist atEhrenkrantz King Nussbaum. "The rally from the end ofSeptember until now was based on the expectation part ofa 2002 recovery. As far as I see it, that phase of thisrally is basically done with. The next phase is going tohave to be more than expectation driven."

So far this

preannouncement season, negative outlooks as a percentage of total projectionshave fallen, but companies lowering their forecastsstill outnumber firms guiding analysts' estimates higher.

Fourth-quarter year-over-year earnings for the S&P500 are expected to drop by 22%, equal to the decline inthe third quarter, according toThomson Financial/First Call. But comparisons are a loteasier this quarter than last because earnings declinedsharply in the fourth quarter of last year.

The Economics of Recovery

After its 11th rate cut last week, the

Federal Reserve is off the radar for a while, and with few bigdata releases next week, economic news won't play amajor role in the market. The biggest piece of data outprobably will be

initial jobless claims data due Thursday,says Mitchell Held, economist at Salomon Smith Barney.

"The question is how much will they bounce back," hesays. "I would be shocked if that number bounced up nextweek."

The weekly initial jobless claims have shown steady improvementduring six of the past seven weeks. New claims fell86,000 during the week ended Dec. 8, taking the numberof first-time jobless filings to 394,000, after a13,000 drop in the prior week.

Other economic reports due next week includeNovember

housing starts,

leading indicators, the

PhillyFed survey, the final version of third-quarter

gross domestic product, theUniversity of Michigan

consumer sentiment index forDecember and

personal income and outlays for November.

Corporate America will rule the headlines, however.And investors will be hoping, again, that greatexpectations show firm signs of turning into reality.