April market performance holds key

The last week in March was not a good one for the stock markets. All the major North American indexes finished down for the four trading sessions to March 28th.

The Nasdaq Composite took the biggest hit, losing 1.26 per cent. It was the second week in a row that the major indexes had lost ground.

There are two main reasons for the market pullbacks, one of which should be of greater concern to investors than the other.

Two reasons for drop:

  • First, and less important, is the growing feeling that the U.S. Federal Reserve Board might begin to raise interest rates as early as May, rather than later in the year as was originally expected.

Although the tone of the Fed’s comments was cautious in announcing last month’s decision to hold the line, the change in tilt from somewhat pessimistic to mildly optimistic has been clear.

The bond market has already reacted by pushing up yields.&t;P>

We need to keep matters in perspective, however. Interest rates are at 40-year lows. The Fed has cut 11 times. We haven’t seen anything like it in memory.

Assuming the economic recovery is indeed under way, some small increases in the coming months are not likely to derail it. Indeed, they are to be expected as part and parcel of a return to economic health.

Second reason more significant

  • The second reason for the drop in the second half of March was more significant: Profit warnings and worry about first-quarter earnings results, which will start coming out in April.

I’ve been saying for months that a sustained market rally is dependent upon a profit recovery. Without significant earnings growth in the coming year, the markets cannot maintain the big advances they’ve made since late September.

In fact, many stocks look overpriced by such traditional measures as price/earnings ratios.

Investors may have pushed valuations too far, too fast. Unless profit gains appear soon to sustain that optimism, the markets are likely to mark time for a while, and could even retreat significantly.

Next page: Profit warnings impact

Profit warnings impact
Recent profit warning from blue-chip giant McDonald’s and a cut in Intel’s profit estimates by the highly respected brokerage firm of Salomon Smith Barney have weighed heavily on the New York markets.

In Canada, bad news from BCE hit that key component of the TSE 300 hard. It dropped 11 per cent in the four trading sessions, making it a major reason why the index ended in negative territory for the second week in a row.

April is critical
Investors’ reaction to negative news from such bellwether stocks explains why I see April as a critical month for the markets.

If  key earnings reports meet or exceed expectations, we could see stocks stage a powerful summer rally, regardless of what happens with interest rates.

Alternatively, if we are hit with a series of high-profile earnings shocks, expect lacklustre markets until late summer.

If that happens, it truly will be a case of: “Sell in May and go away.”

Adapted from an article that originally appeared in the Internet Wealth Builder.