What a Week: Earnings Win

Faster earnings growth trumps China's revaluation, Greenspan's hawkishness and London's terror.
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With so much news shaking up Wall Street this week -- China's yuan revaluation, Alan Greenspan's testimony, new four-year highs on the

Nasdaq

(NASDAQ)

and more terrorism jitters -- it might be easy to overlook one key development for stocks' valuations.

The number of companies whose second-quarter earnings have topped expectations is much higher than normal. While only 40% of

S&P 500

(SPX)

companies have reported earnings so far, 72% of them surpassed expectations, compared with 59% for average quarters, according to Thomson Financial.

That may explain why this week, the major indices continued their upward trend in spite of the heavy news slates. The

Dow Jones Industrial Average

I:DJI

advanced 0.1%, the S&P 500 rose 0.5%, and the Nasdaq gained 1%. The tech-heavy index breached four-year highs on Wednesday.

On Friday, the Dow rose 23.41 points to 10,651.18. The S&P ended up 6.56 points to 1233.88, while the Nasdaq gained 1.14 points to 2179.74.

Selling pressure was felt on Thursday after reports of explosions -- which actually failed, wounding only one person -- revived panic in London, where bombs killed more than 50 two weeks ago.

But chatter was dominated by China's

historic first step toward revaluating the yuan. The possibility that U.S. retailers may have to pay more for imported goods, however, raised concerns over margins and consumption.

The dollar fell upon the news. Heavy selling pressure also was felt in bond pits, which were contending with the prospect that short-term rates will continue to rise for the foreseeable future if

Federal Reserve

Chairman Alan Greenspan's two-day testimony to Congress is any indication.

None of this, however, interrupted the earnings expectations game.

Before the start of earnings season, second-quarter earnings growth was expected to be a paltry 7% from the year earlier. At the current rate, that percentage will easily be in the 10-11% range, says David Dropsey, a research analyst with Thomson.

So far, earnings have on average only slightly topped estimates, maybe by a penny or two, so it's the sheer number of companies involved that are responsible for the improved earnings-growth outlook.

Playing the earnings expectations game has long been part of Wall Street's ways, but for this year's second quarter, "both corporations and Wall Street have been very conservative" when issuing earnings guidance, Dropsey says. Wall Street analysts were expecting tough comparisons with the year-earlier quarter.

"They did a good job lowering expectations throughout the pre-announcement period," he says.

It seems, however, that investors caught up with the game as the trend became clear since last week. This week, when key tech earnings from

Intel

(INTC) - Get Report

,

Yahoo!

(YHOO)

,

Google

(GOOG) - Get Report

and

Microsoft

(MSFT) - Get Report

only slightly topped expectations, the stocks sold off. Some, such as Microsoft, disappointed with their future earnings outlooks. In Google's case, it was more a valuation story.

eBay

(EBAY) - Get Report

, stepped up to the plate, gaining 20% Thursday after its earnings beat estimates by a wide margin.

Overall, expectations had been raised for the tech sector after strong results from

Apple

(AAPL) - Get Report

and

AMD

(AMD) - Get Report

last week, and

IBM

(IBM) - Get Report

on Monday. And that bodes ill for the sector, which has led the market higher since the April lows. The expectations game works best when expectations are lower, not higher.

"Overall, techs

earnings have been steady, at about 14%

year-on-year growth, which is good for any industry, but for techs is nothing to write home about," says Thomson's Dropsey.

That may help explain why the Nasdaq, after its four-year high on Wednesday, began to lose its leadership. On Friday, the tech-heavy index barely made it into positive territory, rising less than the other major indices.

Bigger surprises came from the industrials sector, where besides

FedEx

(FDX) - Get Report

, "each and every other company that reported either met or beat expectations," says Dropsey. Biotechs, likewise, are handily beating expectations, as

Amgen

(AMGN) - Get Report

did Wednesday, while the health care sector as a whole has been disappointing.

For next week, the earnings story likely will come from the energy sector, with oil giants

Exxon Mobil

(XOM) - Get Report

and

ConocoPhilips

(COP) - Get Report

set to report, along with

Marathon Oil

(MRO) - Get Report

and

Valero

(VLO) - Get Report

.

But for those playing the expectations, caution is advised. With some companies having raised earnings estimates as crude oil continued to rise throughout the quarter, and with some already posting results, expectations are running high.

"The sector has seen a huge run-up in earnings

growth projections," Dropsey says. "We started at 13% and it's now expected to grow 37%."

And while weaker crude oil prices had kept a lid on energy shares this week -- crude oil finished the week little changed and below $60 -- things improved after

Schlumberger

(SLB) - Get Report

and

Halliburton

(HAL) - Get Report

delivered strong earnings Friday.

The Amex Oil Index finished the week up 2.6% thank to a 2.6% gain on Friday. On Friday, Halliburton gained 9.4%, Schlumberger while added 4.6%.

To view Aaron Task's video take on today's market, click here

.

In keeping with TSC's editorial policy, Godt doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He appreciates your feedback;

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