We are three-quarters of the way into the Q2 earnings season. According to Factset:

In aggregate, companies are reporting earnings that are 4.4% above expectations. This surprise percentage is slightly below the 1-year (+4.5%) average and also below the 5-year (+5.0%) average.

If the Energy sector is excluded, the blended earnings growth rate for the S&P 500 would jump to 5.4% from -1.3%.

If the Energy sector is excluded, the blended revenue growth rate for the S&P 500 would jump to 1.8% from -3.3%, unchanged from last week.

In effect, margins keep improving ex-Energy.

However, this engine is not well tuned. Half the cylinders are performing well and better while the other half are so-so at best:

Not surprisingly, the so-so half is highly economy-sensitive.

Digging into S&P data, I find that 60% of the non-energy companies having reported so far have positive EPS growth in Q2 with a median growth rate of 16.5% The other 40% are faring much, much worse with EPS dropping 12.5%. Averaging such different performances results in average earnings growing 5-6% when the reality is something else.

Revenue growth is tepid for all sectors but Health Care. Excluding HC and Energy and Materials to eliminate commodity deflation, revenue growth is averaging 1.1% in Q2, 0.6% if Financials are also excluded.

How can margins keep growing with such minimal top line growth?

Consumer Discretionary companies are seeing a huge jump in margins in Q2, thanks to companies such as Amazon (costs cuts), GM and Ford (high margins SUVs). Financials are also doing better as legal costs abate and loans growth accelerates.

  

Health Care providers’ margins seem to want to expand after several years of stability while margins for IT (Google) and Industrial companies are pretty resilient, the latter even in the face of a strong dollar.

  

There is obviously a limit to margin improvements under conditions of near stagnant revenues. In fact, in total, we now seem to be over the top as this Factset chart illustrates.

However, excluding Energy, it seems that this limit was not reached during Q2. Since many pundits currently exclude Energy stocks due to their “special circumstances”, ex-Energy stats have their supporters.

The fact remains that this is clearly a two-tiered equity market: even ex-Energy, 60% of companies are growing with a median growth rate of 16.5% while the other 40% are suffering a median 12.5% earnings decline.

No wonder the lack of breadth in this market! While the growers have average revenues 33% higher than the losers, their median revenues are only 13% higher, mitigating the large company/small company effect.

By industry, the only major difference is that the winners include 14% Health Care companies and 18% Industrials compared to 10% and 22% respectively for the loser side.

The DJI and the S&P 500 have been going sideways since last December but the wider NYSE has been stuck in a sideways channel since July 2014.

YtD, the S&P 500 returned 3.4%, double the return of its equal-weighted version. Last 3 months: +1.4% vs –0.5%.

Equity markets are quite tumultuous underneath the headline indices recently. For example, 21% of all MSCI USA stocks are at least 20% off its 200-day high. The most interesting aspect of this internal correction is the fact that the headline index is a mere 1.8% off the 200-day high.

The pain felt in US stocks is nothing compared to many markets around the world. Canadian stocks have been getting pummelled. 68% of Canadian stocks are in a bear market. This is the greatest percentage of stocks in a bear market since 2011. 30% of MSCI Hong Kong stocks are in a bear market and 29% of MSCI Singapore stocks are in a bear market as well. The true carnage is taking place in the emerging markets, however, where nearly 2/3 of all EM stocks are at least 20% off its 200-day high. Some of the worst countries in EM are Brazil (82%), China (82%), Indonesia (77%), and Russia (81%). (Evergreen/Gavekal)

The S&P 500 Index is flirting with its 200-day moving average which, so far, has proven to be a strong resistance (2 charts below from Ed Yardeni).

But upon further analysis, we can see that this engine is running with only 5 of its 10 cylinders in positive momentum:

Digging further into S&P data, I created two groups of companies that have reported so far, one being composed of companies in sectors which remain in an uptrend as per the charts above, the other composed of the other sectors excluding energy:

• 60% of the companies in an uptrend had positive EPS growth with a median growth rate of +17.5%.
• 40% of the companies in an uptrend had negative EPS growth with a median growth rate of –10.0%.
• 62% of the companies in a downtrend had positive EPS growth with a median growth rate of +12.3%.
• 38% of the companies in a downtrend had negative EPS growth with a median growth rate of –13.0%.

Conclusion: beware averages:

• Growing companies in rising sectors are strong enough to pull the entire market upward, albeit barely.
• Conversely, growing companies in declining sectors are not strong enough to offset the weight of the losers. Their equity also suffer from a sector effect.

Adding Energy companies back in the matrix, we find that 57% of the companies having reported so far show growth in EPS with a median growth rate of 16.5%. The other 43% with declining EPS have a median decline of 15.2%. Given the recent slide in oil prices, looking at equities excluding Energy stocks may no longer be appropriate as the “temporary price drop” looks less and less temporary.

This is not a so-so equity market with so-so earnings. This is more like a twin engine vehicle, one engine pulling forward and one going backward. The resulting standstill gives a false impression that overall things, though admittedly not great, are nonetheless OK.

Not so: this equity market is being pulled by half its cylinders, themselves running at only 60% of their capacity. So far, this has been enough to pull the whole market slightly upward, but unless headwinds abate, one must wonder for how long. The Fed has essentially removed all the additives from the fuel and is threatening to make the terrain even steeper. Meanwhile, inflation is stubbornly low and the ever rising USD blows harder and harder in our face.

This has been a remarkable market winning over so many obstacles. But the engine is sputtering as we enter the treacherous overvalued segment of the journey.

Even the optimists are short of breadth as investors keep pulling money out of U.S. equity mutual funds.

In all, the lack of breadth is pervasive, even spreading within the still rising sectors. This market definitely has bad breadth. Cam Hui goes even further in his excellent analysis:

“Awful” and “abysmal” are probably better descriptions of how market breadth is behaving right now. The chart below shows different ways of measuring breadth. The green line in the top panel is the ratio of equal-weighted SPX to float-weighted SPX (apples to apples comparison with the same stocks, with different weights) shows the narrowness of the leadership and how it has deteriorated since April. The other panels of bullish percentage and % of stocks in SPX above their 200 dma also tell a similar story. The generals are leading the charge but the troops aren’t following.

(…) The current sector leaders are Healthcare (16% of SPX), Consumer Discretionary (11%) and Financials (16%). The laggards are Industrials (11%), Energy (8%) and Materials (3%). So the bulls are winning with a combined weight of 43% in the winning sectors compared to 21% in lagging sectors.

Cam goes on showing that even the winning sectors are breathless, along their earnings profiles:

Let’s look at breadth in the winning sectors. Here is the profile of Healthcare stocks. The top panel depicts the relative performance of the sector compared to the market, which shows that Healthcare remains in a healthy relative uptrend, and the bottom panel shows the relative performance of the equal vs. float-weighted indices within Healthcare (apples-to-apples comparison of the same stocks with different weights). While the equal weighted outperformance ended in April, the bottom panel shows that they remain range-bound and therefore confirms the relative uptrend of Healthcare stocks. So far, so good.

The breadth picture of Consumer Discretionary stocks presents a very different picture. While the sector has been in a relative uptrend against the market, breadth has been deteriorating for all of 2015. Does this look like a healthy advance?

The same comment is true of Financial stocks. The sector began to outperform in May, but saw breadth deteriorate in April, a month before outperformance began.

What about the laggards? Here are the Industrial stocks, which is dominated by GE on a float-weighted basis. Even as the sector underperformed, the equal weighted index underperformed the float weighted index, which confirms the weakness.

Here is the chart of the other large laggard sector, Energy at 8% of the SPX. Even as this sector lagged the market, the troops are running away faster than the generals.

I have heard it said that Technology has been one of the market leaders. That’s not true. Large cap old Tech has performed roughly in line with the market. In fact, some groups within the sector, such as the semiconductors, have badly lagged the market. As well, equal and float-weighted breadth has deteriorated in the past month. However, the high beta glamour stocks, which include many Tech names, have been hot. As the relative performance chart below shows, momentum stocks (top panel) and the all important NASDAQ 100 (bottom panel) continue to lead the market. (…)

The Nasdaq 100 Index is up 8.3% YtD but only 6 large cap names have really driven its performance. Digging further, 59 Nasdaq stocks have positive returns YtD while 41 are losers. This 60/40 relationship is just about everywhere this year!

Fair value for the S&P 500 Index is 2013 as per the Rule of 20 with inflation at 1.8% (core CPI). Trailing earnings are not expected to rise from their current $110.62 level until after Q4’15 (February-March 2016). Trends in inflation are very important in the absence of any meaningful earnings tailwind. Current indications are that inflation will remain below the FOMC’s desired 2% level for some time. Lower inflation is generally supportive for equities (higher P/Es) but the risk is that much lower inflation will further restrict top line growth and/or, at the limit, will spook investors with the D word.

The 200-day moving average has been a good support and, for now, is still rising. But averages can be deceiving. Careful out there!