Seasonally strong stock market period of March-April is almost past and weaker stretch approaches

The S&P 500 Index has rallied very sharply in the past two months by a total of 16% and has posted a new 18-month high. The index has so far retraced 60.2% of the bear market plunge seen from Oct 2007 to March 2009. The S&P 500 is currently up 3.4% on a month-to-date basis and is up 8.4% on a year-to-date basis.

While the two-month rally has been impressive, it has also been in line with the strong seasonals expected in March and April. April is the seasonally third strongest month of the year and March is the fifth strongest. However, we are now coming into the weakest period of the year, which occurs between May and September. The S&P 500 has shown an average 0.41% gain in May since 1950 and then a negligible increase of 0.03% in June. July is typically a strong month, but then the weak months of August and September arrive. The stock market is hitting this more difficult seasonal stretch just as the market is at the top of its one-year rally that has totaled 82%.

The market could easily tire and move into at least a modest downside correction. So far during the one-year rally, the U.S. stock market has not shown a downward correction of more than 10%. There have only been two relatively minor corrections of 9% so far seen in July-July 2009 and in January 2010.

Despite the sharp one-year rally, however, valuations remain relatively modest and leave room for a continued rally in coming years. The forward P/E on the S&P 500 is currently at 15.2, which is slightly below the five-year average of 15.3. At the same time, analysts continue to be relatively conservative in estimating earnings given concerns about visibility and the possibility of new financial crisis events. The fact that analysts are being conservative means that it is easier for companies to beat earnings estimates, thus giving their stock prices a boost. As long as U.S. companies continue to churn out impressive earnings, the market will have no choice but to follow earnings higher in the coming quarter.

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Fundamentals:
The S&P 500 index retreated to a two-week low as it corrects slightly lower from its recent one-1/2 year high. That one-1/2 year high was a 60% correction of the two-1/2 year plunge from the record high in Oct 2007 to last March's 13-year low. Bearish factors include (1) concerns that mounting government debt may derail the global economic recovery after the IMF warned that a failure of nations to contain soaring public debt might have "severe" consequences for the world economy, and (2) comments from Fed Governor Duke who said that "job-market conditions remain weak" and that commercial real estate is constrained by tight credit and probably won't turn around until after an improvement in the broader US economy. Bullish factors include (1) the stronger than expected Mar U.S. leading indicators report (+1.4% m/m), the biggest monthly increase in 10 months, (2) the action by Barclays Capital to hike its forecast for U.S. GDP growth this year to 3.8% from 3.5%, and (3) impressive Q1 earnings in which about 83% of the S&P 500 companies that have reported Q1 results have beaten analysts' estimates, the most for a quarter since 1993.

Earnings expectations for the S&P 500 are as follows, according to Thomson Financial: Q1-2010 (+39.0%), Q2-2010 (+23.6%), Q3-2010 (+24.1%), Q4-2010 (+31.9%), Q1-2011 (+23.6%). S&P 500 annual earnings are expected at +27.9% in 2010 and +20.4% in 2011 (2009 -5.8%, 2008 -23.9%, 2007 -3.7%, 2006 +16.1%, 2005 +13.7%, 2004 +20.2% vs. 25-year average of +8.6%). The S&P 500 forward P/E (based on forward-looking earnings) is at 15.2, just below the 5-year average of 15.3.

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