Hello, Reader.

Earnings season is in full swing, and the reports are coming in near or just above expectations.

It’s not a perfect picture, but we are far enough along to nearly rule out the possibility of a big move to the downside in the market.

We have been getting questions about why we are still mildly bullish when so many financial headlines seem negative. Part of the explanation is that financial headlines usually have a bearish bias. We think it’s the market-news equivalent of “If it bleeds, it leads.”

However, the other issue is that investors tend to suffer from recency bias. That means traders become mentally anchored to values and levels reached recently and ignore longer-term trends.

For example, as inflation has climbed, costs have risen (and continue to rise), and profit margins have come down. According to Factset, profit margins across the S&P 500 should come in around 11.4% this quarter, which continues a decline from the highs 13% in 2021.

On the surface, this seems bad, but profit margins between 8-11% are the long-term norm in the S&P 500, not the exception.

Earnings reports this year are subject to a tough comparison with the windfall profits that occurred in late 2020 and 2021. There is no reason to assume stocks can’t be in a bull market again if profit margins fall back to the long-term average.

The big X-factor this quarter that could keep the market bound inside its recent range is the outlook for growth. Regardless of the current numbers, if the outlook from management is negative, we could see some short-term profit-taking. So, while we don’t think the market fundamentals justify a negative view, we still think being cautious is wise.

The Microsoft Corp. (MSFT) report on Tuesday afternoon is a good example of what we mean by a negative outlook.

The growth in MSFT’s cloud computing platform (Azure) was a stellar 38%, which sent the stock 5% higher in post-market trading.

However, just after the report, MSFT’s CFO told investors that management believes the growth rate will slow by 4-5 percentage points. You can see the whipsaw that occurred in the post-market (blue-shaded area) on the following five-minute chart of MSFT.

The bottom line at this point is that market fundamentals are strong and should keep the market above its lows, but the trend in growth rates needs to improve to justify a strongly bullish outlook.

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Technicals

From a technical perspective, the picture is also good, but with an important caveat. The S&P 500 crossed above its trendline resistance level on Tuesday, a very positive development. However, we are still waiting for confirmation from the other major indexes before getting too excited.

Confirmation from the other major indexes – especially from small-cap stocks would consist of breakouts above their prior highs. For example, although the S&P 500 has crossed a critical technical level, the small-cap Russell 2000 Index is bumping against strong resistance at 1,900.

Waiting for confirmation of a breakout is a classic technique to reduce the possibility of buying a false breakout or “whipsaw.” As long as the Fed doesn’t act too aggressively next week, we think a solid confirmation signal from the Russell 2000 could appear when the labor report is released on Feb. 3.

Bottom Line

When compared to longer-term trends, this earnings season has been good.

The outlook from managers has been mixed, which is a concern, but we don’t see any significant threats to support.

The new breakout on the S&P 500 is encouraging, but we recommend waiting for confirmation before shifting your bias in a more bullish direction.

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