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Does the market's reaction to weak guidance suggest a stock bubble?

Third-quarter earnings season begins next week. Thus far, 108 companies in the S&P 500 have issued earnings guidance and the early results aren't good.

Of the 108 companies that have issued guidance, 89 of these have issued negative earnings guidance, with just 19 companies issuing positive EPS guidance. While the guidance numbers are the most pessimistic on record, I believe the stock market will most likely remain strong through the earnings season.

At the current rate, 82% of companies that have issued guidance have issued negative EPS guidance, which marks a new record high. The previous record was 79%, which was set last quarter when 88 companies issued negative earnings guidance. With the number of companies issuing negative guidance at a record high, you would the market would be showing signs of weakness, but that is not what is taking place.

This could be seen as a sign that the market has entered bubble territory. Stocks have traded down less than expected on negative earnings guidance, and have risen more than usual for positive earnings guidance. It appears clear that Wall Street expects the market to continue trending higher through the remainder of the year, and unwilling to believe that anything can derail the market rally. Unfortunately, this is typically when things start to go wrong.

Investors have already had the chance to react to the negative forecasts, but so far have not been punishing stocks following weak guidance. On average, stocks have lost 0.5% in the two days before and and the two days after a weak guidance announcement. Over the last five years, companies issuing negative guidance lost 0.8% during this same time period, so Wall Street seems less willing to take a bearish tone at the current time.

Another sign that Wall Street wants to continue trading higher is a stronger-than-usual reaction to positive earnings guidance. Companies that issue positive earnings guidance historically gain 3% during the two days before and two days after before and after the announcement, but this quarter they have actually gained 4.2%.

With 82% of companies issuing negative earnings guidance, things are obviously not as good as they appear. Investors need to be aware of the negative picture that is being painted here, and be ready for a sharp selloff once the bubble bursts, and reality returns.

Michael Fowlkes is a financial writer who has been with the Fresh Brewed Media family since 2004. Over the course of his tenure with Fresh Brewed Media, he has worn many hats, including portfolio manager, options analyst, and writer. Michael received his undergraduate degree from Virginia Tech in Accounting and got his start in finance working as a stock trader for six years at Chase Investment Counsel in Charlottesville, Va.


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Michael Fowlkes

Michael Fowlkes is a financial writer who has been with the Fresh Brewed Media family since 2004. Over the course of his tenure with Fresh Brewed Media, he has worn many hats, including portfolio manager, options analyst, and writer. Michael received his undergraduate degree from Virginia Tech in Accounting and got his start in finance working as a stock trader for six years at Chase Investment Counsel in Charlottesville, Va.