Corporate profits are calming U.S. stocks more than any time in 19 years, reducing the cost of insurance against losses at the same time investors gain confidence in European efforts to solve the debt crisis.
The Chicago Board Options Exchange Volatility Index fell 28 percent in the six trading sessions before New York-based Alcoa Inc. (AA) posted results, a record drop before the start of earnings season, according to data since January 1993 compiled by Bloomberg. The VIX, as the benchmark measure of U.S. equity derivatives is known, has fallen 14 percent since Alcoa’s earnings trailed analyst estimates Oct. 11.
Prospects for the eighth straight quarter of earnings growth combined with a pledge by French and German leaders to present a plan by Nov. 3 have helped reduce the VIX from an 29- month high of 48 on Aug. 8. The Standard & Poor’s 500 Index has added 9.5 percent since the VIX climbed above 45 on Oct. 3.
“We were very nervous, and rightfully so, about Europe,” said John Farrall, director of derivatives strategy at PNC Wealth Management in Cleveland, said in a telephone interview yesterday. The firm oversees $109 billion. “Now earnings have taken the forefront of attention, and corporate profits are supposed to be good,” he said.
The VIX fell an eighth straight day yesterday, the longest streak since March 2010, even after JPMorgan Chase & Co. (JPM)’s quarterly report drove the S&P 500 down 0.3 percent. The VIX dropped 8 percent to 28.24 at 4:15 p.m. New York time, falling for a ninth straight day and extending its retreat since Aug. 8 to 41 percent.
The S&P 500 added 1.7 percent today and completed the biggest weekly advance since July 2009. Google Inc. (GOOG) rallied 5.9 percent in its ninth straight gain after the most popular search engine reported sales and profit that beat estimates as businesses spent more to reach online consumers through advertisements.
Traders are placing more bets than any time since 2009 that the VIX will drop, a sign they expect concern about Europe’s credit crisis to recede and the S&P 500 to rally. There were 109 puts to sell the VIX for every 100 calls as of Oct. 12, according to data compiled by Bloomberg.
Profit for S&P 500 companies will climb 17 percent in the third quarter and rise 18 percent to a record $99.86 for all of 2011, according to analyst estimates compiled by Bloomberg. The S&P 500 is trading for 10.9 times forecast earnings for 2012, compared with its five-decade average of 16.4 times reported income, according to data compiled by Bloomberg.
First Day Rally
The gauge added 1 percent on Oct. 12 even after Alcoa’s earnings missed projections by 38 percent. When the S&P 500 rallies on the first day of earnings season, it advances the rest of the period 64 percent of the time, with gains averaging 1.2 percent, according to data since 2003 compiled by Harrison, New York-based Bespoke Investment Group LLC.
“People are not going to gamble on volatility and selling short if they expect positive earnings and good news,” Carlo Panaccione, co-founder of Navigation Group, which oversees $350 million in Redwood Shores, California, said in a phone interview yesterday. “Everybody is expecting a pretty decent earnings season, if not a great one. They’re expecting a rally.”
Analysts have cut projections for S&P 500 per-share profit in the third quarter by 0.9 percent since the start of October, according to data compiled by Bloomberg. Goldman Sachs Group Inc.’s David Kostin, a New York-based equity strategist, said in an Oct. 12 note that he expects a “modest upside surprise.”
The VIX closed at 32.86 on Oct. 11, the seventh-highest level at the start of an earnings season since January 1993, according to data compiled by Bloomberg.
More Than Usual
“Investors are going into earnings with more pessimism than usual, and if you have low expectations, it’s easier for executives to clear them,” Brian Jacobsen, who helps oversee about $400 billion as chief portfolio strategist at Wells Fargo Advantage Funds in Menomonee Falls, Wisconsin, said in a phone interview yesterday. “Sometimes the lack of bad news can be good news.”
The economy isn’t growing fast enough for companies to achieve earnings forecasts, said Jim Strugger, a derivatives strategist at MKM Partners LP in Stamford, Connecticut. U.S. gross domestic product will expand by 2 percent in the third quarter, according to the median of 88 estimates compiled by Bloomberg. That’s down from a prediction of 3.2 percent in August and a peak of 3.5 percent in March.
“Those are significant downgrades to economic forecasts, yet earnings estimates have remained stable,” Strugger said in a telephone interview yesterday. Falling volatility doesn’t necessarily signal that investors believe earnings will exceed expectations, he said.
Finding a Solution
“If anything, it’s related to more constructive news about finding a potential solution to the sovereign debt crisis in Europe,” he said. “This is a shock that began in August that had nothing to do with earnings.”
Equities have rallied this week, driving the S&P 500 up 4.2 percent, after German Chancellor Angela Merkel said on Oct. 9 that European leaders will do “everything necessary” to ensure banks have enough capital.
Since earnings season began, seven of the nine S&P 500 companies that reported third-quarter results beat the average analyst profit projection, according to data compiled by Bloomberg.
“Despite all our consternation about how bad the economy is, I think earnings are going to be pretty good,” Bob Doll, chief equity strategist at BlackRock Inc., which manages $3.6 trillion, said yesterday in an interview on Bloomberg Television’s “In the Loop” with Betty Liu. “Guidance 90 days ago for this quarter was ‘I really don’t know,’ and they’ve come through with pretty good news. Relative to earnings, stocks are very cheap.”