The price-to-peak earnings multiple declined to 11.5x as of last week’s close.  U.S. equities have sold off for two consecutive weeks now, as investors search for confirmation that the six month rally is justified by actual fundamental economic improvement.  This is what Dr. John Hussman refers to as the “show me” phase.  In the last week, with earnings season just days away, the market was sent reeling by weak unemployment data, consumer confidence woes, and a sluggish PMI reading.

As we noted last week, the market’s current swoon matches its behavior during the same period leading into earnings season last quarter.  Third quarter earnings season officially kicks off with the first DJIA company to report, Alcoa (AA), on Wednesday afternoon.  This time around, we expect that stock investors need solid confirmation that an economic recovery is really underway.  Cost cutting has enabled companies to beat analysts estimates for the past two quarters despite generally weak revenues.  However, costs can only be cut so far and Wall Street needs to see improving revenue trends soon.  Furthermore, analysts have been ramping up estimates in order to make up for their overly bearish earnings projections earlier in the year.  Thus, we are not anticipating such a great majority of companies to outpace estimates as we have seen in the last two quarters.

That being said, with earnings coming in nowhere near their peak 2007 levels, the market is not very attractive from a valuation perspective.  While there is no way to foretell the direction of the market in the near term, it seems to us that its risk/return profile is not enticing at present.

The percentage of NYSE stocks selling above their 30-week moving average remains elevated at 91%.  We are getting a very curious dynamic among various measures of sentiment.  Some are continuing to grow more bullish.  The Investors Intelligence survey of stock newsletter editors shows a ratio of 2:1 bulls to bears.  The AAII survey of individual/retail investors is also becoming more bullish standing at 44% bulls to 35% bears compared to last week’s reading of 39% bulls and 45% bears.  Of course, Ockham’s sentiment metric remains off the charts to the bullish side.

However, at the same time, equity fund flows–often considered a gauge for individual investor sentiment–show a $29 billion outflow of cash from stock funds in September.  Meanwhile, bond funds had an inflow of $46 billion during the same time period.  This seems to contradict the surveyed bullishness of individual investors.  In addition, a different index of sentiment from investment newsletter editors betrays an increasingly bearish tone.  Bullishness as measured in the Hulbert Stock Newsletter Sentiment Index has declined from 45.2% to 29.1% in a period of less than two weeks.

In each case, these sentiment indicators are showing contradictory results while polling the same community of investors.  We will continue to monitor the overall trends in sentiment, but we believe that that bulls remain in control as affirmed by our sentiment indicator.

The market is again at a crossroads with an extremely important earnings season on deck.  The market has already priced in substantial economic improvement and a quick return to pre-recession earnings levels.  If the recovery is in fact slower and weaker than this, we would not be surprised to see stocks pull back, perhaps significantly.

It will come as no surprise that our asset allocation model remains defensively positioned right now.  The 50%+ rally from the March lows has been impressive, and the S&P 500 just completed a second straight quarter of double digit gains.  Such a performance in consecutive quarters has not happened since 1985.  Long-term investors would be wise to reduce risk in their portfolios following such impressive market gains.

It is probably a bit simplistic to call it “buying the rumor”, but Alcoa (AA) is trading about 5% higher the day before they kick of second quarter earnings season.  The stock was given a major boost when Klaus Kleinfeld, Alcoa’s CEO, made optimistic remarks during an interview on Bloomberg television.  Kleinfeld said that he is encouraged by the rebounding economies of the United States and particularly China.  He said, “China is clearly out of the woods…It’s economy has come back and is growing.”  The “green shoots” of the U.S. economy are also positive for his business, which should get a boost from the automobile industry as sales trends suggest is beginning to rise from the ashes. 

Alcoa is America’s largest producer of aluminum and their stock has been hammered by the downturn in the world economy.  It was less than a year ago that the company’s stock was over $30, but slacking demand and falling prices of base metals sent the stock reeling to a low of just below $5.  Year to date aluminum prices have seen a slight up-tick of about 5%, but Alcoa’s stock is off by about 9% over the same period.  As Kleinfeld said, much of the increased demand that is driving the price of metals up is coming from China.  Of course, most of the Chinese demand has been absorbed by Aluminum Corp. of China, aka Chinalco (ACH), which has seen their stock rise by two-thirds so far this year.  However, the fact that demand is starting to return is still important news for the struggling Alcoa.

Alcoa is expected to report another dismal quarter tomorrow, which will in all likelihood be its third straight quarterly loss.  Consensus analysts’ estimates are expecting a loss of $.37 on revenue of $3.9 billion, which would be a decline of about 48.5% in sales.  Because of the destruction of Alcoa’s fundamentals we downgraded the stock to Overvalued when the stock rose into the $10 range in early May, and it has yet to break significantly above that.  If Mr. Kleinfeld is correct and the company shows encouraging results then the stock will get a boost from it, but we will still not advocate buying until the fundamentals are much stronger.  We are hopeful that the results tomorrow will show an improved operating environment, but it would be nothing short of a miracle for the company to return to profitability this quarter.  Of course, that is a major strike against any stock we value, and with Chinalco absorbing much of the increased demand from China and the dollar’s recent strengthening, there are still significant headwinds for Alcoa.

Alcoa may be cheap compared to historical norms, but it is no longer cheap enough to warrant our attention given its crumbling fundamentals.  It is of course interesting to see the market gravitate to the optimistic tone of the CEO, and we would be pleased to see the company beat expectations.  However, this company is not strong enough yet to get our stamp of approval.  This may be a classic case of “buy the rumor, sell the news” as the CEO has lifted expectations, perhaps unintentionally. 

“Alcoa will be one of the first to report. The stock is counter-cyclical it has 3% pop to the up side. Why do you think that’s happening? What is the buzz on Alcoa?…

The buzz is that they are likely to lose 36 cents a share versus gain of 67 cents a share last year.  We expect the company to be hit by the lower aluminum costs or prices as well.” Fox Business Network 7/7/2009

Analysts were expecting a pretty rough quarter from Alcoa (AA) with aluminum prices still low and industrial demand depressed.  Alcoa swung to a loss in the last quarter with at 28 cent per share deficit, and that number was expected to grow in the first quarter with consensus estimates predicting a 57 cent loss per share.  Revenue was expected to slow considerable to $4.08 billion, representing a 44.7% drop from last year.  Alcoa fell as much as 5% and finished the day down 2% for Tuesday’s trading as traders feared the results would be even worse than forecast.

The pressure was on Alcoa to deliver in this make or break earnings season.  Revenue actually topped estimates ever so slightly coming in at $4.1 billion.  However, the loss was worse than expected coming in at 59 cents per share, totally $497 million.  They will be cutting cap ex by 50%, which totaled $471 in the first quarter.  The results were not all that bad, as Alcoa was successfully able to raised $1.4 billion in a convertible note offering, also the company was able to reduce the cost to produce aluminum by 33%.  The stock is trading slightly higher in after hours.  But as Fox Business Network reports, there is still a lot of excess capacity in aluminum and it could be some time before that ramps up again,

“One thing we look at the aluminum or metal’s business is a utilization rate. Alcoa is down to a 75% utilization rate at their plant. That speaks to a bigger issue. When we start to recover, we have so much express capacity that short term you may make money on Alcoa, but it will be a long time before they are ramped up again.”

Fox Business Network’s Money for Breakfast with Alexis Glick is the way many investors, both professional and individual, get a jump on the day.  The show airs for two hours from 7am ET until half an hour before the opening bell.  So, the show gives a rundown of the stories that will impact the trading day, and also brings some important earnings announcements that come  out before the opening bell.

Much of the conversation today revolved around the beginning of earnings season, which truly begins tomorrow with Dow component Alcoa (AA).  Furthermore, the other major story this morning, was that talks have stalled between IBM (IBM) and Sun Microsystems (JAVA) over the potential merger.

“One of the big stories developing out of the world of technology where that deal everybody was so excited about a few weeks ago between IBM and Sun Microsystems looks like it might be falling apart. A number of published reports this morning say the deal for IBM to buy Sun is on the brink of collapsing that is really hurting the Sun Microsystems stock price in the premarket as you might expect. Down about 20, 25 percent there to $6.43 a share from the $8.49 IBM by the way on this word nothing final yet that the deal might not happen is also lower $101 from $102.”  Fox Business’s Money For Breakfast on Monday, April 06, 2009

“We have to go to Robert Gray for breaking news with Alcoa…Yeah, Alcoa slashing their quarterly dividend down 3-cents a share from 17-cents. They are also going to sell $1.1 billion in common stock in convertible notes to raise cash here.”

Fox Business Network broke this news right as the market closed today.  We wrote just last week (Cramer: Alcoa’s Dividend is at Risk) that Alcoa (AA) was going to be forced to take some sort of action to preserve cash in the coming weeks.  Cramer has speculated that an announcement would be made in the next week, and he was correct, it was only 4 days later. 

This is not a surprise of course as the company had planned to pay out 68 cents this year and dividends, but they are anticipated to lose more than 60-cents a share during the year as well.  When something has to give, it is usually going to be the dividend first, as much as a firm may not like it.  Details of the Alcoa announcement are available here.  The company is going to streamline cost structures as well, in addition to cutting the dividend.  Furthermore, there will be the secondary offering of shares.  Not surprisingly, the shares are trading more than 10% lower in after hours.  The stock is clearly Undervalued, and now that the shoe has dropped there may not be that much more downside risk.

Alcoa Research Report