First-Quarter Earnings Season Will Test Rally

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Updated from 3:16 p.m. ET to include additional information on the performance of the major U.S. equity indices in the past week and year-to-date.

NEW YORK ( TheStreet) -- With every passing positive session, it becomes more difficult to question the legitimacy of the current rally in stocks. Maybe it's appropriate now to switch gears and think about what could come along and derail this train.

A weak read on consumer sentiment aside, few would argue the economy isn't on reasonably solid footing right now with the employment picture improving, inflation in check, and even housing percolating a bit.

The Federal Reserve acknowledged as much earlier this week, sparking Tuesday's surge in the major U.S. equity indices that's led to all these big, round numbers being conquered.

"Information received since the Federal Open Market Committee met in January suggests that the economy has been expanding moderately," the latest statement began, omitting a reference to "slowing global growth" that was included in January. "Labor market conditions have improved further; the unemployment rate has declined notably in recent months but remains elevated. Household spending and business fixed investment have continued to advance."

So what's to worry about then? Higher gasoline prices could be problem, potentially prompting consumers and businesses to slow spending. Greece is out of the woods for now but it's not like the region's problems are solved or the prospect of a recession in Europe is off the table. The thing is though, these factors are well known and investor appetite for equities hasn't slowed nary a bit.

What may be more helpful is to get a bit more basic, and ask whether corporate earnings growth in 2012 is going to support continued gains for stocks. UBS, which has a year-end target of 1475 for the S&P 500, weighed in on the subject earlier this week.

" We expect the market to push higher over the remainder of 2012," the firm said in a research note on Monday. "However, the underlying dynamic driving stock prices is likely to shift. More specifically, we believe that the recent liquidity-driven bounce has most likely run its course, and that earnings will lead stocks higher in coming months, with P/E expansion providing only modest support."

Now the exodus out of bonds on Tuesday following the Fed's statement may have provided a bit more near-term liquidity, but the premise is still valid. One anomaly of this rally has been that fourth-quarter earnings season was very ho-hum, and expectations for the first quarter, which ends in two weeks, have been dropping.

According to the latest data from Thomson Reuters, analysts are currently looking for earnings growth from the S&P 500 of just 2.8% for the first quarter, down from projections of 5.5% as of Jan. 3 and 10.2% as of Oct. 3. That's right; over the same span that the S&P 500 has logged a 25%-plus gain, pushing to close above 1400 on Thursday for the first time since June 2008, earnings expectations have steadily sunk.

Warning season starts soon but there's already a good amount of outlooks to sift through and the data isn't good. So far, 113 S&P 500 companies have provided guidance, more than 20% of the index's components, and 76 of those have been negative, or 67%. Ten companies were in line with the consensus view (9% of the total), and 27 were above (24%). That makes for a 2.8-to-1 negative/positive ratio, above both a 1.9X ratio in last year's equivalent quarter and the 2.3X long-term aggregate ratio, which is based on data dating back to 1995.

While there's still a few name-brand earnings reports trickling in -- notably Oracle ( ORCL) and FedEx ( FDX) on Tuesday and Thursday next week respectively -- the real test for this rally will probably come in mid-April when the big banks start reporting.

JPMorgan Chase ( JPM), which also contributed to the buying frenzy this week with its announcement of a dividend increase and $15 billion buyback, will kick things off on April 13, so it's not too soon to start considering whether the company is going to be able to back up the 34%-plus move in the stock in 2012. The same goes for Bank of America ( BAC), up more than 65% year-to-date and making a run toward $10 late in Friday's session.

A robust round of reports from the big banks would go a long way toward validating these advance, and providing some support for the broad market. After all, Apple ( AAPL) can't be expected to shoulder the whole earnings load forever.

As 2012 wears on, analyst expectations for earnings increase with the S&P 500 seen posting profit growth of 9.1% in the second quarter, 5.2% in the third quarter, and 15.8% in the fourth quarter, according to Thomson Reuters. But those projections will come down if companies have trouble clearing the low bar set for the first quarter, and that could bring the profit-takers out of the woodwork.

Also worth noting is that the verdict on first-quarter earnings season won't be in until roughly halfway through May, and every investor knows the old adage about the fifth month: Sell in May and go away.

Stocks finished mixed on Friday, taking a breather after storming higher earlier in the week. The Dow Jones Industrial Average fell 20 points to finish at 13,233, breaking a seven-session winning streak. The blue-chip index is up 8.3% so far in 2012 after rising 2.4% in the past week. The Nasdaq Composite closed down a point at 3055, but it's up an incredible 17.3% year-to-date.

The S&P 500 was the only major U.S. equity index to finish in positive territory on Friday, rising less than 2 points to 1404. The index enjoyed its best weekly gain in three months, also rising 2.4%, and it's now appreciated 11.5% in 2012 on a price basis.

-- Written by Michael Baron in New York.

>To contact the writer of this article, click here: Michael Baron.

Disclosure: TheStreet's editorial policy prohibits staff editors, reporters and analysts from holding positions in any individual stocks.

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