by Chris Johnson, IDE
Those who know anything about me know that my approach to forecasting market moves is detecting when expectations are out of alignment with the underlying fundamental and technical pictures. I follow these expectations by watching investor behavior via a number of quantified measures. The result is the ability to detect when investors are likely to move money in and out of the market to reach an equilibrium or balance between their expectations and stock prices.

Those who know me are also aware that I love earnings season. Nothing gets the juices flowing every day more than a healthy dose of earnings reports. Each contains the “seeds of opportunity” that I talked about last week.

The best part is that earnings season has a ways to go. And that means there are plenty of opportunities remaining to take advantage of surprises and disappointments. And as I’ve said many times, knowing the expectations beforehand can go a long way to being positioned properly before the earnings number hits the tape.

Last week’s earnings focus was on the 40 percent of Dow stocks scheduled to report quarterly results. This week, we enter a more robust period of announcements that favors the S&P 500 Index. To put this into perspective, around 250 companies announced earnings last week. This week holds more than 800 reports.

At this point, the implications of a heavier flow of earnings should be a positive as the market moves toward new highs. Barring a sudden shift in the trend of earnings surprises, the market should continue its run based on the unwinding of investor fear and the positive catalyst of earnings reports that outpace expectations (69 percent of the reporting S&P companies have beaten estimates so far).

While the S&P 500 has the highest percentage of companies reporting, the Nasdaq 100 Index (NDX) has a larger number of high-profile companies entering the earnings confessional. The tech-heavy index boasts earnings from the likes of Amazon (huge upside surprise on Tuesday), Sun Microsystems (disappointing forecast), Microsoft, Apple, Qualcomm, and Texas Instruments (bullish forecast boosted the stock). These earnings create volatility and movement. And that creates opportunity.

Given the high-profile nature of the NDX companies reporting this week, I expected to see higher volatility play into the bulls’ hand. And that’s what’s happened. As I put pen to paper (or, more accurately, finger to keyboard), the NDX is up 1.4 percent this week to the Dow’s 0.4 percent, even though the buzz is around the Dow taking out the 13k mark.

Equally as important is the NDX leaving the 1,845 level in its wake. That’s rarified air for the NDX, which hasn’t seen these numbers since July 2001. This breakout should cause those who had been holding out for such a break to capitulate and pour more of their money into the market.

Last week, of course, the tables were turned, with the Dow turning in a 2.5-percent gain compared to the NDX’s 1.5 percent. Just goes to show you what a slate of good earnings results can do for you.

So how is the market positioned as we make our way through the heart of earnings season? My model continues to signal that the market should move higher. Investors now appear to be rushing to buy stocks to avoid feeling left out of the rally. Like auction buyers who realized that they don’t want to let a good opportunity slip away, they’re bidding up prices. That means that there’s an increased chance that we’ll see the market’s rally take stocks to the next level.

Many investors and traders have noted the market’s recent resilience. The number of days that the Dow and other indices have moved lower through the day, only to close in positive territory, is impressive. I refer to this situation as the market having a “built-in bid” on stocks. The term refers to the fact that there are investors willing to step up and buy on a small drop in prices. This is bullish for the intermediate term since it indicates that the demand for stock is greater than the supply.

Looking at sentiment, I’m seeing what is referred to as “unwinding pessimism,” which means that traders are becoming more bullish by moving money back into the market. There’s solid technical support and apprehensions about weak earnings growth is melting away with each new report hitting the wires. Those who anticipated this scenario by noting the high level of pessimism heading into earnings are already in the market. They’re watching their portfolios benefit from those who are rushing back in after staying on the sidelines.

If you haven’t jumped on board the earnings rally, it’s not too late. Plenty of companies have yet to report (more than half, in fact), meaning that profits will be available for the taking.

Earnings season is a great opportunity. So are low expectations and unwinding pessimism. Combining these elements could make the next few weeks the best trading environment in 2007. Don’t let it pass you by.

Investor’s Daily Edge (www.investorsdailyedge.com) is a free investment newsletter that’s delivered by email before the market opens. In each weekday issue you’ll receive clear recommendations and practical.

Before starting Johnson Research Group LLC (JRG), Chris worked in the financial services industry as a broker for 11 years and eight years as Director of Quantitative Analysis and Market Strategist with Schaeffer’s Investment Research. Through this work, Chris became an expert at quantifying and studying the behavior of investors and financial markets, market sectors, and indices.

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