7/1/2009
By Brian Sozzi, Research Analyst

Second quarter earnings season is approaching at warp speed, and in many cases it's put up or shut up time for corporate America.  It's widely held as gospel that the banking sector (minus regional players) enjoyed one heck of a party in the second quarter, benefiting from the perfect storm of cheap government money that was loaned out at high rates, fat fixed income spreads, and strong underwriting fees as companies took advantage of the improved economic climate to issue debt and equity.  Considering that banks hold significant representation in the S&P 500, it's not entirely far-fetched to imagine the index shifts out of its recent consolidation gear and puts rubber to the road.  By putting rubber to the road, however, I do not mean a material move higher as the S&P 500's advance from the March nadir (+36.0%) suggests the pricing into equities of a robust second half recovery in economic conditions.  Nonetheless, upside earnings reports from banks as a result of the aforementioned factors, and likely bottom line beats by others that comprise the S&P 500 due to cost cutting measures and scant inventory on the books could be enough to get sideline money into the fray.  Beyond second quarter earnings season, my sense is that we will require more than stabilization in economic data sets to justify further gains in equities; on the contrary we will need definitive signs of improvement.

Against this backdrop, I believe it's a dangerous proposition to allocate capital to consumer discretionary equities.  Whether it's a retailer of pricey apparel or a sit down dining eatery, chances are if the stock is publicly traded it has surged from the depths of hell seen in March.  As a visual example, check out the direction of the Morgan Stanley Cyclical Index (+100.0% from March) and the Morgan Stanley Consumer Index (+33.0% from March), both up handsomely during the last three-months.  The buying activity into the underlying index stocks has been primarily on hope for a rosier second half economy rather than indications of a fundamental turn for the better in sales and operating margins (ex. items of course).  An inability for these indices to breakout in June is telling, and should not be overlooked.  In my view, the rebuilding of savings and balance sheet de-leveraging on the consumer side of the GDP equation are powerful forces that will play out well into 2010, which equates to fewer dollars in the hands of merchants selling discretionary goods or services.  Despite efforts to cut operating expenses and squeeze the supply chain, the lack of demand will cause a recalibration in valuation of consumer discretionary equities as investors realize there is more to growing profits than simply jettisoning unproductive employees and loss leading store/manufacturing sites.