Growth

• Second-quarter total net income expected to be down 28% year-over-year
• Third quarter expected to be down 23.5% year-over-year
• Staples and Health Care only sectors expected to post positive growth in second quarter
• Only 31.5% of reporting companies post earnings growth; 24.0% post sales growth year-over-year

Surprise

• Early results much stronger than expected; the median surprise is 6.7%
• Early positive surprises lead disappointments by 3.9:1 margin
• Surprise ratio above 6:1 for Health Care, Tech, Discretionary and Materials
• Margins the cause, not revenue growth
• 72.7% of firms beat on earnings; 46.3% beat sales estimates

Full-Year Forecast

• Bottom-up estimate for S&P 500 now $60.20 in 2009 versus $60.12 last week.
• S&P 500 now expected to earn $74.42 in 2010 versus $74.41 last week
• Top down estimates $54.19 and $68.48, respectively

Revisions

• Total estimate increases outnumber cuts by almost 4:3 for 2009
• Upward revisions outnumber cuts by almost 7:6 for 2010
• Level of increases small given positive earnings surprises
• For 2009, Staples and Health Care lead; Utilities, Telecom lag
• Tech and Materials also look good for both years

Valuation

• S&P 500 P/E at 16.39x based on 2009 earnings - an earnings yield of 6.1%
• P/E of 13.26x based on 2010 Earnings - an earnings yield of 7.54%
• Earnings yields attractive relative to treasury and corporate bond yields
• Health Care has lowest P/Es of any sector

Total Net Income Growth

• Early results are absolutely bad, but better than expected
• Total net income reported $108.9 billion versus $147.5 billion last year, down 26.2%
• Only 31.5% of all reports show positive year-over-year EPS growth; just 24% show sales growth
• Only Staples and Health Care show positive growth so far
• Remaining firms expected to post 33.4% decline
• Materials and Energy expected to see massive year-over-year declines

Earnings are coming in much better than expected with 2/3rds of the reports in. The source of the positive surprises is coming from much better-than-expected margins (both operating and net) rather than from better-than-expected revenue growth. In other words, companies are succeeding in cost cutting their way, if not to prosperity, then at least much better-than-feared results.

While at the individual company level, this is almost always a positive, it is not necessarily so at the macro level. Cutting costs by reducing head count means that there are fewer jobs and less overall demand in the economy. Still given the weak state of the economy, I suspect most investors will not be too picky about the source of the earnings improvements.

The one exception to this might be in the financials, where the earnings quality is weak due to FASB caving to political pressure and doing away with mark-to-market accounting. On the other hand I have not seen any situations of massive mark-to-market of the liabilities but not the assets like we saw in the first quarter.

The total earnings from the 333 firms that had reported by the Jul 30 close were $108.9 billion, a decline of 26.2% from the $147.5 billion those same firms reported a year ago. However, on a sequential basis, earnings are up 9.3% from the first quarter pace. Actual earnings growth has been a pretty rare commodity with only 105 of the 333 (31.5%) reporting firms actually posting higher net income than a year ago.

Perhaps even more surprising is that only 80 (24.0%) have seen an increase in revenues. Total revenues for the 333 firms are 14.8% below last year. The median EPS growth rate is -16.4%, while those still left to report have a median expected EPS growth rate of 0.9%. While the median EPS growth reported is largely in line with the total net income decline, there is a big difference when it comes to those yet to report. The total net income of the remaining firms is expected to plunge 33.4%, which is far worse than what we have seen so far, as well as very different from the median.

Keep in mind that medians are inherently equally weighted with the growth rate of a relatively small firm counting as much as that of an Exxon Mobil (XOM) or a Wal-Mart (WMT). Also changes in share count can affect EPS growth, but not total net income growth.

Total Net Income Growth (Reported)
Sector	Q4 '08 A	Q1 '09 A	Q2 '09 A	Q3 '09 E	2008 A	2009 E	2010 E
Cons. Stap.	3.39%	-8.88%	14.83%	-4.96%	8.48%	-0.09%	10.24%
Health Care	8.38%	-0.34%	1.74%	-5.38%	12.85%	-2.82%	9.39%
Utilities	5.30%	11.63%	-1.95%	-1.61%	4.03%	-0.99%	5.81%
Financials	-375.49%	-1.75%	-15.40%	-3.65%	-77.06%	59.60%	53.05%
Technology	-21.99%	-26.26%	-16.51%	-21.18%	19.89%	-13.84%	25.92%
Cons. Disc.	-62.43%	-52.97%	-17.97%	-2.68%	-15.58%	-17.55%	42.99%
Telecom	-16.95%	-19.34%	-28.59%	-18.84%	-5.38%	-20.51%	5.35%
Industrials	-21.08%	-36.70%	-33.01%	-37.39%	-0.90%	-32.62%	8.58%
Materials	-79.40%	-72.98%	-61.83%	-72.95%	-11.09%	-62.77%	86.06%
Energy	-30.23%	-58.07%	-66.81%	-62.44%	20.95%	-56.56%	42.12%
S&P	-39.13%	-27.30%	-26.20%	-27.45%	-13.37%	-19.49%	24.39%

Total Net Income (Reported)
Sector	Q2 '09	Q2 '08	Q1 '09	Q1 '08
Health Care	$23,575	$23,172	$23,532	$23,613
Financials	$17,518	$20,706	$18,377	$18,704
Technology	$16,686	$19,985	$13,795	$18,709
Industrials	$14,417	$21,520	$11,804	$18,647
Cons. Stap.	$10,877	$9,472	$8,708	$9,557
Energy	$9,179	$27,657	$9,630	$22,968
Cons. Disc.	$6,543	$7,976	$3,972	$8,446
Telecom	$4,890	$6,848	$5,270	$6,533
Materials	$3,061	$8,020	$2,060	$7,621
Utilities	$2,139	$2,181	$2,447	$2,192
S&P	$108,886	$147,538	$99,594	$136,988

Total Net Income Growth (Not Reported)
Sector	Q4 '08 A	Q1 '09 A	Q2 '09 E	Q3 '09 E	2008 A	2009 E	2010 E
Financials	-13563.08%	-107.65%	11.42%	-137.19%	60.61%	-77.49%	-251.67%
Health Care	6.39%	11.96%	3.66%	4.32%	8.14%	4.12%	8.14%
Cons. Stap.	-0.14%	-4.10%	-6.41%	-9.88%	22.89%	-2.04%	10.69%
Utilities	-3.62%	-6.90%	-10.26%	0.93%	0.73%	-2.65%	10.19%
Telecom	-20.70%	-11.61%	-16.60%	1.92%	-1.40%	-6.81%	21.14%
Industrial	-2.93%	-23.29%	-30.61%	-32.03%	18.11%	-26.98%	-0.02%
Cons. Disc.	-156.26%	-31.03%	-33.24%	-8.68%	-42.17%	23.79%	25.82%
Technology	-9.50%	-28.75%	-39.87%	-28.04%	20.60%	-25.07%	14.72%
Energy	-16.11%	-65.57%	-70.36%	-66.77%	23.67%	-61.91%	52.82%
Materials	-110.23%	-107.47%	-79.48%	-46.38%	-46.11%	-68.19%	175.79%
S&P	-119.60%	-26.73%	-33.35%	-10.44%	-32.16%	13.00%	21.51%

Total Net Income Growth (Combined)
Sector	Q4 '08 A	Q1 '09 A	Q2 '09 E	Q3 '09 E	2008 A	2009 E	2010 E
Cons. Stap.	1.54%	-6.34%	3.93%	-7.44%	15.47%	-1.10%	10.47%
Health Care	8.22%	0.52%	1.90%	-4.65%	12.48%	-2.30%	9.29%
Utilities	-0.63%	-1.45%	-7.42%	0.08%	1.79%	-2.10%	8.73%
Financials	-992.86%	4.20%	-12.52%	244.18%	-106.77%	-639.32%	52.83%
Technology	-18.78%	-26.97%	-22.89%	-22.79%	20.08%	-16.86%	23.20%
Cons. Disc.	-96.07%	-43.30%	-24.67%	-5.11%	-27.35%	-2.99%	35.27%
Telecom	-17.12%	-18.99%	-28.06%	-17.91%	-5.21%	-19.91%	6.16%
Industrials	-19.82%	-35.61%	-32.78%	-36.88%	0.54%	-32.12%	7.76%
Materials	-81.98%	-74.07%	-62.77%	-71.69%	-13.36%	-62.99%	89.17%
Energy	-26.01%	-60.57%	-67.97%	-64.01%	21.87%	-58.39%	45.46%
S&P	-58.59%	-27.16%	-27.98%	-23.52%	-17.96%	-12.93%	23.64%

Second-Quarter EPS Growth (Reported)
Sector	2Q '09 (A)	3Q '09 (E)	2008 (A)	2009 (E)	2010 (E)
Healthcare	9.48%	4.49%	15.79%	5.78%	10.28%
Cons. Stap.	3.75%	-3.61%	9.76%	1.84%	9.33%
Utilities	0.00%	0.99%	5.80%	-0.93%	7.32%
Telecom	-5.97%	-7.07%	1.44%	-4.17%	6.96%
Tech	-18.42%	-21.05%	9.72%	-14.16%	13.75%
Cons. Disc.	-19.75%	-16.67%	-7.49%	-14.57%	10.63%
Industrial	-24.26%	-24.74%	10.44%	-20.22%	12.17%
Materials	-33.33%	-34.62%	-4.62%	-36.45%	13.34%
Financial	-38.46%	-26.92%	-25.65%	-30.00%	8.96%
Energy	-56.52%	-65.79%	21.40%	-58.30%	17.71%
S&P 500	-16.40%	-16.47%	5.40%	-13.00%	10.76%

Second-Quarter EPS Growth (Not Reported)
Sector	2Q '09 (E)	3Q '09 (E)	2008 (A)	2009 (E)	2010 (E)
Tech	16.00%	26.32%	16.98%	17.74%	11.97%
Telecom	5.45%	23.30%	11.23%	-5.20%	4.54%
Utilities	0.85%	8.51%	4.62%	3.99%	7.47%
Cons. Stap.	0.00%	5.19%	9.66%	7.55%	10.15%
Healthcare	-2.56%	5.26%	12.07%	0.00%	10.04%
Financial	-9.49%	-15.59%	17.22%	2.01%	3.80%
Industrial	-14.75%	-7.50%	17.24%	29.41%	6.10%
Materials	-14.81%	17.78%	7.38%	-39.86%	9.39%
Cons. Disc.	-23.81%	-9.52%	11.81%	-1.33%	11.85%
Energy	-66.67%	-13.70%	12.96%	21.19%	9.99%
S&P 500	0.85%	8.51%	4.62%	3.99%	9.85%

Surprises Scorecard:

• Positive surprises are leading disappointments by 3.9:1 margin
• The median surprise is a very strong 6.74%
• All sectors but Telecom have more positive surprises than disappointments
• Materials and Consumer Discretionary the leaders on the surprise front
• Tech, Health Care and Staples also doing better than expected

Second-Quarter Scorecard (Surprises)
Sector	% Reported	Median % Surprise	# Pos Surprise	# Neg Surprise	# Match
Healthcare	79.25%	6.12%	35	5	2
Cons. Stap.	51.22%	6.17%	16	4	1
Utilities	31.43%	3.39%	6	3	2
Telecom	55.56%	0.00%	2	2	1
Tech	64.47%	7.69%	34	5	10
Cons. Disc.	60.49%	11.76%	43	6	0
Industrial	84.48%	5.88%	37	8	4
Materials	82.14%	15.09%	18	2	3
Financial	77.22%	6.12%	36	21	4
Energy	57.50%	3.03%	14	6	3
S&P 500	66.60%	6.74%	241	62	30

The Zacks Revisions Ratio: 2009

• Revisions ratio for full S&P 500 up to 1.32, from 1.19
• Given the level of positive surprises, the increase in the revisions ratio is very small
• Five sectors are in positive territory; Staples and Health Care lead
• Industrials, Utilities and Telecom continue to see estimates cut
• Ratio of firms with rising-to-falling mean estimates up to 1.26, from 1.02
• Total number of revisions (4-week total) up to 3,467 from 2,560 (35.4%)
• Increases up to 1,972 from 1,389 (42.0%); cuts up to 1,495 from 1,171 (26.8%)
• Total Revisions activity rising rapidly, nearing seasonal peak

So far, this is looking like the story of the dog that didn't bark.

Yes the revisions ratio has edged up, but given the magnitude and number of positive surprises in second-quarter earnings, one would expect a flood of positive estimate revisions. After all the second quarter is part of the full year 2009, so if a company beats the estimates for the quarter, and the analysts do not raise their estimates for the full year by the amount of the beat, then they are implicitly cutting their forecasts for the third and fourth quarters.

There is a very good possibility that this is simply a lag effect in the data, as the pace of reports has really picked up in the last few days. If so, we should see the revisions ratios rise dramatically over the next few weeks. We have seen a dramatic increase in total revisions activity, which is normal for this point in the earnings season, but cuts have increased almost as much as increases have. This is a subtle, but very disturbing sign.

The defensive Staples and Health Care sectors are doing the best on the revision front. However, Materials is about as cyclical a sector as you can think of and it has shown a great improvement in its revisions ratio, apparently in response to the much better-than-expected earnings in the sector. Tech is also having a better than expected earnings season, and in response its revisions ratio is also strong. However, positive surprises are leading disappointments by 9:1 in Materials and by almost 7:1 in Tech. Thus, I find a 2:1 lead over estimate increases for the year that includes those surprises to be a little underwhelming.

Generally, in the Staples and Health Care sectors the analysts tend to be in tight agreement about the expected earnings (small standard deviation around the mean estimate). These sectors, therefore, will not show up on screens of the biggest estimate revisions. On the other hand, it means that even small changes in the mean estimate can be significant, and it is best to look for large numbers of analysts changing their estimates in one direction, rather than for big changes in the mean estimate.

There are a number of companies that are worth mentioning for the estimate revisions activity. In Staples, Hershey (HSY) is looking sweet and Phillip Morris (PM) is smoking, while the grocery stores Supervalu (SVU) and Safeway (SWY) are very weak.

In Health Care, the drug companies like Amgen (AMGN), Bristol-Myers Squibb (BMY) and Wyeth (WYE) seem to have found the right prescription. In Tech, the analysts found Apple (AAPL) to be very tasty. They also like chip stocks such as Texas Instruments (TXN)

Sector	Avg. 4wk EPS Change (FY1)	Revisions Ratio	Firms With FY1 EPS Increase	Firms With FY1 EPS Decrease
Consumer Staple	0.18%	3.05	26	12
Health Care	1.52%	2.73	42	10
Materials	2.31%	2.03	19	7
Technology	2.95%	1.98	43	19
Consumer Disc	0.02%	1.54	45	30
Financial Services	-2.89%	0.99	31	45
Energy	-3.85%	0.84	20	19
Industrials	-3.30%	0.69	18	37
Telecom	-1.88%	0.67	2	6
Utilities	0.17%	0.25	12	19
S&P 500	-0.41%	1.32	258	204

The Zacks Revisions Ratio: 2010

• Revisions weaker for 2010 than 2009, but still net positive
• Revisions ratio rises to 1.16 from 1.10
• Tech, Staples showing best estimate momentum for 2010
• Industrials, Telecom and Utilities getting cut
• Ratio of rising to falling mean estimates rises to 0.95 from 0.93
• Total revisions activity past lows for the quarter
• Total number of revisions rises to 2,925 from 2,142 (36.6%)
• Estimate increases up to 1,572 from 1,123 (40.0%); cuts up to 1,353 from 1,019 (32.8%)

Sector	Avg. 4wk EPS Change (FY2)	Revisions Ratio	Firms With FY2 EPS Increase	Firms With FY2 EPS Decrease
Consumer Staples	0.50%	3.96	24	7
Technology	2.73%	2.52	35	24
Materials	0.16%	1.78	15	12
Health Care	-0.17%	1.59	35	17
Consumer Discr	-2.46%	1.43	35	40
Energy	-0.83%	0.81	23	17
Financial Services	-3.84%	0.72	23	47
Industrials	-0.74%	0.58	18	36
Telecom	-2.72%	0.44	2	7
Utilities	-1.10%	0.44	7	18
S&P 500	-0.81%	1.16	217	225

Valuation - Earnings Shares and P/Es

• Health Care expected to take earnings crown from Energy in 2009 and keep it in 2010
• Energy's earnings share expected to plunge to 11.1% from 23.2%
• Financials' 2009 earnings share expected to rise to 11.5% from -1.7% in 2008
• 12-month forward S&P P/E of 14.51 equates to earnings yield of 6.89%. This is very attractive relative to the 10-year T-note yield of 3.48% and somewhat attractive relative to 5.15% A-rated 10-year corporate.
• Health Care the lowest P/E sector for both 2009 and 2010; its market cap share (index weight) is well below its earnings share
• Earnings share, including historical, based on current make up of S&P 500

Earnings Shares and P/Es
Sector	2008%	2009%	2010%	Market Cap %	P/E 2008	P/E 2009	P/E 2010
Technology	16.63%	16.01%	15.95%	19.27%	16.5	19.7	16.0
Health Care	16.13%	18.11%	16.01%	13.43%	11.9	12.2	11.1
Financials	-1.69%	11.46%	14.16%	13.23%	NM	18.9	12.4
Cons Staple	12.91%	14.68%	13.12%	12.87%	14.2	14.4	13.0
Energy	23.17%	11.09%	13.04%	11.61%	7.1	17.2	11.8
Industrials	13.53%	10.56%	9.20%	9.80%	10.3	15.2	14.1
Cons Disc.	6.80%	7.58%	8.30%	9.42%	19.8	20.4	15.1
Utilities	4.56%	5.07%	4.45%	3.84%	12.0	12.4	11.4
Materials	3.79%	1.61%	2.47%	3.28%	12.3	33.3	17.6
Telecom	4.18%	3.84%	3.29%	3.25%	11.1	13.9	13.1
S&P 500	100.00%	100.00%	100.00%	100.00%	14.3	16.4	13.3

Neil Malkin contributed significantly to this report.

Data in this report, unless stated otherwise, is through the close on Thursday 7/30/2009

Zacks Investment Research

Incyte reported GAAP net loss of $40 million, or $0.41 per share, compared to net loss of $45.6 million, or $0.54 per share, in the year-ago period, in line with Zacks Consensus Estimate. The primary reason for earnings growth is lower operating expenses. During the second quarter, operating expenses fell 18.9% year over year to $33.52 million.

R&D expenses for the quarter were $29 million, down from $38.1 million in the year-ago period. The decline is due to the company’s prioritization of developmental programs. In order to ensure optimum utilization of resources, Incyte is currently focusing its R&D efforts on clinical programs with the greatest near-term value.

SG&A expenses remained unchanged from the year-ago period at $4.1 million. Interest and net other income expenses for the quarter reflect a non-cash charge of $1.3 million relating to FAS 115-2, the new guidance on mark-to-market accounting effective from this quarter.

The last quarter was quite encouraging for Incyte’s pipeline. Earlier this month, the company reached an agreement with the US FDA regarding the design of a pivotal phase III trial for its lead candidate INCB18424.

The drug is being developed for the treatment of different types of myelofibrosis, a disease without any existing treatment at present. Incyte is progressing well with its other candidates as well.

Without a foreseeable candidate on the market before 2011, Incyte is under further financing pressure for its ongoing operations. We remain concerned about the company’s cash position. At the end of the second quarter, its total consolidated debt was $401.2 million, with cash and cash equivalents of $114.3 million.

With the liquidity scenario easing a bit, Incyte may look for debt restructuring but did not provide details during the conference call. We think the company may need to tap the capital market in 2009. An equity offering will dilute the current shareholder base and be an impediment on the path to positive earnings. We have a Hold rating on the stock.

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Here are highlights from Tuesday's Analyst Blog:

FASB Changes Accounting Rule

The rules will certainly improve the transparency of the banks' balance sheets. In the stress tests recently conducted, the Federal Reserve had estimates of assets likely to be brought onto the balance sheet as a result of these amendments. It is estimated that 19 banks subjected to stress tests would have to bring about $900 billion of assets onto their balance sheets.

In their latest regulatory filings, Citigroup (C) estimated that the rule change would result in consolidation of $165.8 billion in additional assets, and JPMorgan (JPM) estimated it to be $145 billion.

We think that the new rule is a very positive move by FASB, after the much criticized and much debated revision allowed by it (under intense pressure from Congress) on mark-to-market accounting recently.

Pacific Ethanol Subsidiaries Bankrupt

Pacific Ethanol (PEIX) disclosed that lenders agreed to $20 million in debtor-in-possession financing.

Kinergy is the ethanol sales and distribution arm of Pacific Ethanol. It sells ethanol made by Pacific Ethanol as well as ethanol made by Midwestern producers. Pacific AG sells wet distillers feed grain to California's big dairy industry. The grain is a byproduct of producing ethanol, made after the fermentation process.

Pacific Ethanol is at a disadvantage to many of its rivals. It had to buy most of its corn from the Midwest, which raised its operating costs. The company also buys some corn in California. Pacific Ethanol said it plans to sell its ethanol and feed production under existing agreements.

As recently as 2007, the ethanol industry had a bullish outlook. However, with high corn prices it's become a very difficult market for ethanol producers. There are currently 10 other ethanol producers in bankruptcy, including VeraSun Energy (VSUNQ) and Aventine Renewable Energy (AVRNQ).

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The good news is that there will be plenty of opportunities going forward, regardless of which of the above scenarios plays out.

Bull Market Rally Scenario

The move that we have recently seen, i.e., 24.82% in the Dow Jones Industrial Average ($DJI), 26.82% in the S&P 500 (SPX), and 28.26% in the Nasdaq (COMP), from the lows made in early March to the highs made just 4 weeks later, suggests a larger move could be in store.

For one, it's generally believed that a 20% rise in the stock market, marks the beginning of a bull market. Likewise, a -20% decline in the stock market, signals the start of a bear market.

Secondly, the market had become terribly oversold (by Mar 6). You can see this on many technical oscillators such as the Relative Strength Index. (See the chart below.)

S&P 500 Index

- close as of Thursday, Mar 2, 2009

It can also be quantified by the sheer number of new 52-week lows that were made in individual stocks while the market indexes were making new lows. In fact, each successive major new low made in the market (S&P 500: 839.80 on Mar 10 2008, 741.02 on Nov 21 2008 and 666.76 on Mar 6 2009), brought with it fewer new individual 52-week lows each time, with the difference being in the thousands between the last lows in March 2009 and the 'first lows' in October 2008.

This shows the market has either gotten ahead of itself or that perhaps too much value has been stripped out of the market. Either way, the market indexes are simply a composite of individual stocks. And if fewer and fewer stocks are able to make new low, an upside test ultimately has to take place.

Thirdly, the major indexes are all trading above their shorter-term moving averages (10- and 20-day) and medium-term moving average (50-day).

This clearly shows the market's recent momentum has turned positive.

S&P 500 Index

- close as of Thursday, Mar 2, 2009

And fourthly, on the fundamental front, there has been a steady stream of massive initiatives aimed at getting the financial sector and the broader economy moving again. The markets have reacted to these new developments, such as the second stimulus, the buying up of toxic assets and the purchase of US Treasuries.

In addition, the Financial Accounting Standards Board (FASB) also made their long awaited decision on mark-to-market accounting for mortgage backed assets to something closer to "significant judgment" when valuing these assets.

Combine this massive action from the U.S. with other significant steps taken from countries all around the world, and the market seems to be in a 'let's see if this will work' mode.

Plus, recent earnings have come out better than expected on many companies (not necessarily stellar, but not as bad as feared) suggesting that maybe things have stopped getting worse, or at least the pace at which thing have been getting worse has slowed.

Who knows if this is THE BOTTOM or just a bottom. If it is THE BOTTOM, then statistics show that a much larger move is in store. In fact, in a study of the Top 10 Worst Bear Markets since 1929 (using the Dow Jones), the average increase within one year of the lows was +55.62%.

I don't want to get ahead of myself, but the 3-year increase is +77.56%. And the 5-year increase is +103.41%.

Dow Jones Industrial Average

Bear Market Rally Scenario

The case for this being just a bear market rally, is just as compelling, and sadly, maybe even more so. But this does mean it is and in fact, may even work against it being so.

First, let's address the 20%+ upswing we've seen in the market.

While it's true, a bull market won't officially be called until there's been a 20% increase, not all 20% increases turn out to be bull markets.

In fact, as the below chart illustrates, while the market was collapsing between 1929 and 1932, there were six 20%+ rallies that ultimately fizzled. And the market ultimately made new lows in 5 of those 6 instances. Of course, the 6th time turned out to be the charm, culminating in a 172.17% rise within the next 12 months.

Dow Jones Industrial Average

So while the 20% increase is a hopeful sign of life, it's far from being a done deal.

This is already our second 20%+ rally (low to highs) within just the last six months. (Three, if you count the +24.25% jump within just 3 days in October 2008.) Aside from that, we saw a 22% rally between December 2008 and January 2009. In the current rally, we're up 24.82% so far. Of course the previous rallies failed, so we'll just have to wait and see.

Dow Jones Industrial Average

- close as of Thursday, Mar 2, 2009

Second, while the market had recently been oversold, thus precipitating the rally, the oversold conditions have indeed been relieved, with conditions now reversing themselves and getting close to being potentially overbought.

It's also ironic and worth pointing out, that even though the market has been charging higher, the last part of this rally (except for this past Thursday) has been made on declining volumes. Is the rally running out of buyers or believers already?

S&P 500 Index

- close as of Thursday, Mar 2, 2009

(Note: the market's recent rally has bounced back to the underside of its bearish Descending Triangle foreshadowed the recent downside breakout. And meaningful pullback from these levels could signal more downside to come. But an upside breakout would nullify this pattern's bearishness and remove a technical negative to the market. (See the chart below.)

S&P 500 Index

- close as of Thursday, Mar 2, 2009

There have also been some spectacular gains made in many individual stocks. Far greater than the averages reflect. And quite large for arguably one of the worst economic and business environments since the great depression.

This has lead to an increase in valuations as well. The P/E ratio for the S&P 500 on Mar 6, 2009 when the last lows were made, was 11.16x 2009 estimates. Within a few short weeks, the P/E surged to 13.33. That's a 2.17-point increase or 19.44%. The run-up in the P/E ratio essentially mirrors the price increase without any real increase in projected earnings.

Third, it's true the short-term moving averages (10-day and 20-day) and medium-term moving averages (50-day) are reading positive, the longer-term moving average (the 200-day) is still negative (above the market and trending lower still).

The bright spot is that it's quite a ways away from current levels. And since the 200-day moving average often acts as a long-term moving trendline (markets usually test and retest trendlines as the move up and down), a test of this important moving average, even if it gets turned away, could mean higher prices are still in the offing.

Dow Jones Industrial Average

- close as of Thursday, Mar 2, 2009

And fourth, while there has been a tremendous amount of action to get the banks and the economy rolling again, none of this is guaranteed to work.

There have been some great ideas put forth. But sadly, there's a lot of politics involved and we have all seen how irresponsible some in Congress can be. This is important to note because the administration has said that it needs the private sector to be a partner in this. But the recent fiasco over bonuses from the first TARP funding, and the resulting hysterics that followed in Congress, has made the private sector very leery about 'doing business' with the government. This is evidenced by several big recipients of bailout funds, pledging to give it back as fast as they can to decouple themselves from the long and intrusive hand of the government.

Conclusion

So what does one do?

There are clearly cases to be made for this being the beginning of a bull market rally or just another bear market rally.

Whatever it turns out to be, there are plenty of opportunities to make money.

For one, in October, when the market completely fell apart, it was almost impossible to make money on the long side of the market. The metaphor I like to use for that time is that it was like raining knives. Hard to not get hurt in that kind of market.

But as we outlined earlier, each successive new low in the market witnessed fewer stocks making new lows, which shows that many stocks are starting to trade based on their own individual merits. This of course can be both good and bad. But it allows for the reward of individual stock analysis, and that's what we're all in the market for in the first place. To be rewarded for finding the right stocks to invest in and make money.

And with billions of dollars of stimulus getting pumped into the economy, there will be plenty of winners in the months ahead.

Focus on companies with the best Zacks Rank that also have real earnings growth, in the present year and in the future. Pay attention to the earnings estimate revisions, as they can be your first warning sign of trouble or good times ahead.

I would also look at the technicals, especially chart patterns, as I believe they give clues as to when a stock will breakout and in what direction.

Omniture, Inc. (OMTR) and Vertex Pharmaceuticals (VRTX) are 2 great examples and they are both stocks I picked for the Chart Patterns Trader service.

Both of these stocks have just broken out: Omniture to the upside (we are long based on a bullish Inverted Head and Shoulders pattern) and Vertex to the downside (we are short based on a Bear Flag pattern).

OMTR is a leading provider of online business optimization software, allowing customers to capture, store and analyze information from web sites and other sources, including social networking sites like Twitter for instance.

This is an exciting company with dramatic increases in earnings projections. The numbers are small, but the projected gains are impressive. In 2008, OMTR posted 2 cents. In 2009, the company is projecting 12 cents. And in 2010, they're expecting 25 cents. Big growth, in a dynamic industry.

VRTX discovers, develops and markets small molecule drugs that address major unmet needs. The company has several drug candidates in development including teleprevir, a drug for HCV infection, i.e., Hepatitus C, the most common form of liver disease.

However, data from phase III trials for teleprevir won't be submitted to the FDA and the EU's EMEA until the second half of 2010 with the company then expecting approval in 2011 if all goes well. In the meantime, VRTX lost $3.25 per share in 2008. Is expected to lose $3.27 in 2009. And $3.07 in 2010. Hence our short position.

Regardless of the market, there's opportunity no matter what and in either direction.

Great Trading,
Kevin Matras

Kevin directs the Chart Patterns Trader, a service that combines Zacks Rank fundamental power with pinpoint technical timing.

During today's crossroads market, Kevin and his team comb through hundreds of stock charts. No matter which way the market turns, they're finding companies poised to make sharp price moves. Certain chart patterns have proven to be uncanny predictors - with success rates up to 70%.

Markets do not function as smoothly during a financial crisis. As such, the benefits for mark-to-market accounting that the financial institutions received during good economic times have now reversed, forcing them to take big losses, albeit we suspect temporarily.

The new mark-to-market guidelines were designed to allow the "toxic assets" to be "fairly valued" to reflect current market conditions, thereby creating an "orderly" sale, rather than a forced or "distressed" sale. This should make it easier for companies to avoid having to take impairment charges on their investments. However, the determination to what would be the "fair value" will be left to the financial institutions' best judgments.

In addition, this easing of guidelines creates a conflict with the Treasury's plan for using the Public Private Investment Fund (PPIF) removing "Toxic Assets" from financial institution balance sheets. Under the easing, financial institutions would have an incentive to keep these assets on their books, rather than selling them. However, we suspect this could still result in "Zombie" institutions that will wait for these asset/securities to roll over their books, rather than taking a loss and getting on with the business of making loans.

As we stated last week, both Bank of America and Citigroup were aggressively buying these types of assets, bidding up prices. This leaves us to question if these companies had any foreknowledge of what FASB was going to present to the House Subcommittee, which stated (we paraphrase) --- If you don't come back quickly with the proposal we want, we will legislate FASB to do it.

The easing to guideline is effective from 2Q09 forward. We think that the rule change is an attempt to financially engineer results for institutions such as, but not limited to, Bank of America (BAC), Citigroup (C), Wells Fargo (WFC) and U.S. Bancorp (USB) in the short-term. This will enable them to hide the potential losses on their toxic securities --- potentially skewing the "Stress Testing" that is currently going on in order to hide the potential for insolvency for some of the largest institutions deemed "too big to fail."

It does not matter if you are for or against mark-to-market accounting. What should be infuriating to investors is that changing the accounting rules to allow the "fair and reasonable" valuation to be determined to the individual company's internal people is ludicrous. It first removes any application of a "reasonable man" theory, and reminds us of what occurred in the aftermath of the French Revolution.

It should be a wake-up call if China basically chastises you for your accounting practices.

However, this will make the accurate valuations of companies' assets very difficult, and in the long term it may drive away investors due to doubts about the accuracies of their financial statements.

This from Money Morning:

If there’s a proverb that captures the outlook for the U.S. economy in the New Year, it’s the one that says: “It’s always darkest before the dawn.”

Regardless of any formal announcement of whether or not the United States drops into an actual recession, the ongoing credit crisis guarantees a contraction of the American economy by virtually every measure…

And it gets worse. That increase in borrowing costs will spread to other parts of the global debt market, representing an across-the board threat to corporate, institutional and sovereign borrowers. If interest rates remain high and interbank lending remains tight, the credit crisis is not likely to recede.

This raises two key questions. Are desperate times prompting desperate measures? Is LIBOR being manipulated by banks that are trying to make their financial positions appear better than they really are?

If that’s the case, it’s one more…

As part of the just-passed U.S. bailout bill, the government has reiterated the Securities and Exchange Commission’s authority to relax the mark-to-market standards. If the SEC actually follows through on that directive, many professional investors worry that we won’t catch on to the next leg of the ongoing credit crisis until it’s way too late.

While politicians point to mark-to-market rules as the cause of the billions in write-downs and losses suffered by financial firms in recent quarters, in fact, it was mark-to-market accounting that first exposed the underlying problems in the complex markets for mortgage-backed securities (MBS) and credit-default swaps (CDS).

“Mark-to-market is reality-based accounting,” said Money Morning Contributing Editor Shah Gilani in a phone interview yesterday (Tuesday). “Anything else requires a looking glass and a ticket to Wonderland.”

“To me, mark-to-market accounting is the clarion sound of beagles barking, letting transparency hunters know down which dark hole the fox is hiding,” said Gilani, a former hedge-fund manager who recently penned a five-part investigative series on the U.S. credit crisis – including an alternate bailout plan that he says would’ve cost taxpayers very little.

Without the early warnings raised by mark-to-market accounting standards, the problems in the CDS market could have gone unnoticed for much longer, leaving no time to hedge or prepare for the ultimate carnage to the financial sector.

“In the past couple of weeks, fair-value accounting has been under attack,” JPMorgan Chase & Co. (JPM) analyst Dane Mott wrote in a recent report, Bloomberg News reported. “Blaming fair-value accounting for the credit crisis is a lot like going to a doctor for a diagnosis and then blaming him for telling you that you are sick.”

Prior to the current credit mess, mortgage-backed securities were priced according to Markit’s ABX Index, which used the average weight of four series in the index to track the price of housing derivatives. But once the subprime market collapsed, the ABX Index plunged - and has yet to recover.

Mark-to-market accounting standards kicked off a round of write-downs at global financial firms that highlighted the overexposure of many to these risky securities. Without such standards, investors would have been unaware of the coming credit crunch.

The Rise of Fair Value

Mark-to-market accounting, or fair-value accounting as it is sometimes called, arose partly in response to the U.S. Savings & Loan Crisis of the late 1980s and early 1990s. Financial institutions had inflated the value of assets on their books, which ultimately led to their financial collapse.

In order to bring more order and transparency to financial firm balance sheets, there was a shift from valuing balance-sheet assets at their purchase price to holding assets at fair market value – or the price the assets would fetch out in the marketplace if they were sold.

In mid-November, with the U.S. subprime mortgage crisis already taking its toll on global financial firms, the Financial Accounting Standards Board (FASB) released Statement No. 157, entitled “Fair Value Measurements.”

Due to the timing of its issuance, FASB 157 has been pointed to by many as a cause for the financial crisis currently gripping the United States and other markets abroad. But it is important to note that FASB 157 only clarified the fair-value accounting practices that had already been in place for decades – with perhaps one noted exception.

"FASB 157 is not the primary cause of this crisis - greed and poor judgment are," Paul Shifrin, a principal at SC&H Group LLC, a Maryland CPA and management-consulting firm, said in an interview with Money Morning.

What FASB 157 did introduce was an asset hierarchy based on the market available for the assets. Assets are assigned to one of three categories based upon how liquid the assets actually are and, in turn, how easy they are to value, or price:

• Level 1 assets are fully liquid, and easy to price.
• Level 2 assets can be priced with the benefit of "comparable assets."
• And Level 3 assets are completely illiquid and nearly impossible to price.

A Growing Crisis

As the market for MBS and collateralized-debt obligations (CDO) dried up, financial firms were caught holding billions in securities for which there was no longer a market. That led to a steep decline in prices and huge write-downs, which translated into escalating quarterly losses. These complex securities, which had been “Level 1” assets, were quickly becoming “Level 3” assets.

But rather than place the blame on the over-leveraging or the risky securities in question, some politicians and banking lobbyists blamed mark-to-market accounting for the resulting huge losses at global financial firms.

“Onerous mark-to-market rules for certain financial assets that have no market value have worsened the credit crisis, and changing them has been a priority for House Republicans,” U.S. Rep. John Boehner, R-Ohio recently told The Wall Street Journal reported.

Congress and such financial-firm lobbying groups such as the American Bankers Association have called for a relaxing of the mark-to-market rules. But doing so would represent a grave error, says Money Morning’s Gilani.

“Nobody is going to trust anybody,” says Gilani. “That’s a real problem if you do away with mark-to-market accounting.”

And that’s an even bigger problem in a market that is already seized up with a crisis of confidence.

The main argument against fair-value accounting is that in a “disorderly market” such as the one we have now due to the ongoing credit crunch, mark-to-market doesn’t take into account the actual cash flow of CDO securities or if the owner plans to hold those securities until maturity. In other words, the security could be worth more than the current sale price if it is held and not sold.

"It’s a knee-jerk reaction from politicians and the banks are trying to find a scapegoat to blame for their own errors in judgment," said SC&H Group’s Shifrin.

If mark-to-market rules are relaxed or eliminated, financial firms will be able to hide future errors in judgment from investors, allowing corporate executives to falsely protect their companies’ share prices, and to protect their own salaries and bonuses.

“To suggest you don’t track and report fair values means you end up in a world where management still knows the real prices, as do market counterparties, but not the investors,” Sam DiPiazza, chief executive officer of the accounting firm PricewaterhouseCoopers, told The Financial Times.

This from Today's Financial News:

You may not believe it, but our elected officials are not morons. In fact, they are very smart, calculating businessmen. The measure profits not in dollars but by votes. Unfortunately, the world of politics is far more corrupt than Wall Street.

I do not know why I am surprised by this bailout-bill mess. After all, you do not make it to Capitol Hill by acting charitable, selfless or even ethical. You make it to Washington through back-stabbing political moves, shady campaign contributions, and a me-before-you attitude. The truth is blatantly obvious this week.

After Monday’s political debacle permanently smeared this country’s history, our kind senators thought they would step in and look like the heroes we have been waiting for. In dominating fashion, they passed a revised version of the administration’s bailout bill.

It was the Senate’s way of saying to their rivals in the House, “Ha, ha. We are better than you.”

It was also their way of taking advantage of the American taxpayer. Realizing the House absolutely must pass a bill or face severe political consequences, the Senate added over $150 billion worth of pork.

There are tax relief measures for alternative energy and technology research. There is funding for rural schools. And there is even a measure that forces companies and healthcare providers to increase their mental health treatment standards. The bill is filled with laws that would have failed on their own.

Other than this pork, the new package is almost financially identical to the original failed bill. It still provides $700 billion in bailout relief, the only thing Secretary Paulson ever asked for. It still gives the government non-voting warrants in the companies it is giving the money to. It still creates a channel, not an official limit, to cap executive pay. It still offers mortgage help to trouble homeowners. And it still creates an oversight committee that has the power to cancel the entire bailout anytime it wants.

The only new legislation that is even remotely beneficial to the country and the American taxpayer is a measure that would increase federal deposit guarantees from $100,000 to $250,000, while giving the FDIC unlimited borrowing potential.

When it comes down to it, even the guarantee increase is more political pandering designed to make the average Joe feel like the government is doing something good for him. In reality, how many Americans are going to run out and toss another hundred grand into their checking account? What impact will it have on banks with balance sheets ready to implode?

Wait, it gets better

Oh yeah, our senators are pulling the wool over our eyes with one other new measure. The new bill calls for a “study” of the effects of changing current bookkeeping standards and the impact of mark-to-market accounting on corporate balance sheets. Our leaders must not have gotten the memo on August 28 telling them the SEC voted to switch the nation over to international accounting standards. They would have to jump through a lot of very high hoops to make any serious accounting changes. But they do not expect you to know that.

Really, it is no surprise this kind of legislation came out of the Senate. After all, it is home to both presidential candidates and one vice presidential candidate. They saw the opportunity as a chance to make headlines and pander to the “unintelligent” voter.

Fortunately, you and I know better. We know our elected officials are full of, well, politics.

The new legislation will get voted on late tonight or sometime tomorrow morning. It will pass and our leaders will be clamoring to get their face in front of the cameras so they can read us a canned speech and add some more votes to their coffers.

As investors, this bailout bill will be just another factor in the giant equation that makes Wall Street so complicated. If you pay attention, do your homework, and do not fall for the lies and the hype, you have a very good shot at profiting from Capitol Hills work.

After all, no new law passes unless it will make somebody rich. Might as well be you, right?

Source: Bailout Bill: Corrupt Politicians Steal Your Money

Dirk van Dijk, CFA, Director of Zacks Equity Research: I'm not sure how many accounting principals are more fundamental than "lower of cost or market."  There are some transactions being done between willing buyers and sellers.  That is the best way of finding out what the "true" value of something is.  Suspending mark-to-market is just an attempt to hide the real condition of the banks -- it allows them to pretend that the garbage on their books is really gold. 

Isn't misrepresenting the values on your books the very core of the idea of securities fraud?  That is all that doing away with mark to market would be, legalizing and legitimatizing securities fraud.

Jason Napodano, CFA, senior drug industry analyst: I'm not sure what transactions you're talking about, Dirk, but from what I've heard the market for these types of securities is completely illiquid.

It's impossible to mark-to-market when you have absolutely no idea what the market is.  There's got to be a better option than, "No one is buying it, so it must be worth zero" mentality.  Bernanke and Paulson both stated they would probably buy many of these securities at prices above what is being marked on banks' balance sheets right now.  If we can come up with a reasonable pricing mechanism for the value of stock options, then a similar formula should be able to be put into place to calculate the value of mortgage-backed securities.

Prices are artificially low due to a combination of fear and illiquidity. I suspect that if all these funds were held to maturity, they would return far greater value then their current mark-to-market price.

Sean P. Smith, senior travel & leisure industry analyst: There has been a market for these securities, just not one to which the banks have been willing to mark their assets.

At the end of July, Merrill (MER) agreed to sell $30.6 billion gross notional amount of CDOs [collateralized debt obligations] to Lone Star Funds for $6.7 billion. That would equate to roughly $0.22 on the dollar. However, to complete the deal, Merrill had to provide financing to Lone Star for 75% of the purchase (approximately $5 billion).

The loan was non-recourse, meaning Lone Star could put the CDOs back to Merrill should the CDOs deteriorate, and Lone Star would only be out the $1.7 billion in equity it put up. In essence, Lone Star paid about $0.055 on the dollar.

I doubt things have improved in the last two months.

Ann Northrop, CFA, senior communications and restaurant industries analyst: I thought Jeff Diermeier,  CEO of the CFA Institute, summed it up well in his September 23rd letter to legislators and regulators. He argued for mark-to-market accounting with optional disclosure of alternative valuation criteria, such as companies that report certain cash flow metrics or EBITDA do now. 

He went on to posit that it is capital adequacy and not reporting requirements that should be flexible in chaotic financial times. Here is an excerpt and the link to the letter follows:

"Complaints about fair value arise largely in the context of their impact on capital adequacy. Rather than suspending fair value and thereby the transparency and relevance of financial information, perhaps the focus should instead be on flexibility in capital adequacy requirements in times of distress. This is a much more direct and transparent means of dealing with the capital issues."

http://www.cfainstitute.org/centre/topics/comment/2008/080923.html

Eric Rothmann, senior financials and insurance industries analyst: The one place that we should never be "flexible" is capital adequacy.  If there was more emphasis on the quality and quantity of capital, the taxpayers would in all likelihood be on the hood for a lot less.

Ann Northrop: Looks like the SEC has eased mark-to-market accounting.

http://news.yahoo.com/s/nm/20081001/bs_nm/us_usa_accounting_sec

Dirk van Dijk: "By clarifying how to treat assets in an uncertain market, the SEC is continuing to provide transparency to investors and helping institutions to provide credit in periods of market stress."

Yeah, the best way to provide transparency is to paint over the windows with black paint and then hang heavy curtains in front of them.

Ann Northrop: Looks like they're paving the road to the next disaster.  In the meantime, I would imagine this will greatly reduce the multiple investors are willing to pay for bank stocks. How can anyone know what they are really buying? (Thanks, Ann, for passing this along to all of us.)

Looking at some of the components of the index, new orders plunged to 38.8 from 48.3, production fell to 40.8 from 52.1, and employment was down to 41.8 from 49.7.  From a GDP accounting perspective, there was a little bit of good news as the export index is still above the 50 neutral line at 52.0, but that is down from 57.0 in August.  The import index fell to 44.0 from 48.5.  This should help a bit on the net export side of GDP growth, but trade improvement from imports falling faster than exports (well exports still appear to be expanding but less rapidly than before, and rising exports have been just about the only bright spot in the economy lately) is not a healthy development.

Also today, the Mortgage Bankers Association reported that its index of total mortgage applications fell 23% last week, despite overall mortgage rates holding steady.  The refinance index collapsed by 34.7%, while the index for new purchases was down 10.7%.  Clearly we are nowhere close to being out of the woods on the housing front.  The takeover of Fannie FNM and Freddie fre does not seem to have done much to free up mortgage lending yet.  The longer the credit freeze goes on, the greater the damage will be.

I would still avoid the Financials in here.  The idea of abandoning mark-to-market accounting is just a desperate attempt to sweep the problems under the rug.  That is the mildest way I can put it.  We need more transparency in the financial statements of the banks, not less.  This is an attempt to repeal one of the most basic rules of accounting, namely that assets should be valued at the lower of either cost or market.  With this change, the books of every major financial institution will belong on the fiction shelf.  Fairy tales can make for enjoyable reading, but you don't want to rely on them for making investment decisions. 

Longer term, there will be some real winners among the banks.  I suspect that J.P. Morgan (JPM) and U.S. Banks (USB) will fall into that category, but I would wait at least a few months before getting into them.  Avoid the weaker banks like National City (NCC), Fifth Third (FITB), Key (KEY), Downey (DSL) and Regions Financial (RF) like the plague.  Sure, they may have days when they pop up by 20% or so, but they will also have days when they are down 20%, and there will be more of the latter than the former.  You would have more fun in Vegas, anyways.

Read the full analyst report on USB

Read the full analyst report on NCC

Read the full analyst report on FITB

Read the full analyst report on KEY

Read the full analyst report on RF