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The stock-market tug-of-war of recent weeks reflects a battle between companies making bundles of cash and countries that seem badly short of the same.
In the past several days, sentiment has shifted back and forth as investors have alternated between worries about the U.S. debt ceiling debate and euro-zone debt woes and excitement about strong earnings from companies like Apple (AAPL), Coca-Cola (KO) and McDonald's.
With the U.S. debt-ceiling deadline Aug. 2 and the euro zone still fumbling about what to do with Greece (and Ireland and Portugal and Italy and Spain), the market has plenty of externalities to worry about. The question is: What will ultimately win out, earnings or Everything Else?
Based on the past week, earnings are gaining the upper hand, which makes sense. While the euro and U.S. debt issues are serious, odds are they won't lead to a terrible calamity. Moreover, as long as the fiscal problems persist, it is more likely that central banks will keep interest rates very low. When interest rates are low, stocks are relatively more attractive since returns in fixed-income assets are largely tied to interest-rate policy.
With the economy limping along, corporate earnings strength might seem anomalous. But it isn't. Part of the issue is that companies have become more productive and efficient. But a bigger reason for the dichotomy stems from the global nature of many companies, big and small.
Take Apple, which reported blowout earnings last Tuesday. The company said it had $28.57 billion in sales during the quarter as it sold every iPad it could make. But less than half of those sales -- $10.13 billion -- came from the Americas. In an increasingly globalized world, the U.S. economy isn't the only game in town, something oft-overlooked.
So, even as the economy records growth in gross domestic product of around 2%, companies are reporting far stronger earnings gains. Analysts expect companies in the Standard & Poor's 500-stock index to increase earnings by about 15% in 2011 and another 15% in 2012. That's nothing like the 40% gain in earnings seen in 2010, but it is still strong.
Politicians in the U.S. will probably dicker on the debt right up until the Aug. 2 deadline. When it seems a deal looks likely, stocks tend to jump, mainly because focus then turns to the strong earnings. That occurred last Tuesday when the Dow Jones Industrial Average jumped more than 200 points after President Barack Obama showed optimism that a deal would get done.
The stock market's fixation on the debt-ceiling debate is not being reflected in the Treasury market or the currency markets. In a default scenario, the Treasury market -- home to all the U.S. debt -- ought to react badly. But the market has remained quite firm as the Washington rhetoric has become more fractious. The benchmark 10-year bond sports a yield of 3%, which is historically very low.
Markets aren't perfect, but the behavior in the Treasury and currency markets indicates that a lot of smart money believes the politicians in Washington will eventually come to some sort of deal to avoid default.
One reason that the dollar and Treasurys remain strong is that the real sovereign-debt problem is not in the U.S. In Europe, politicians are struggling to fix Greece's fiscal mess. The euro-zone debt crisis dates back to early 2010 when Greece first said it needed help meeting its financial obligations.
The Eurocrats rescued Greece last year, but the fix hasn't worked. So, now a second rescue is being debated, without much success. During the long Greek drama, Ireland and Portugal have also required rescues. More recently, Italy and Spain have become targets of speculators who fear they will need some sort of funding help.
The U.S. and euro-zone debt issues will continue to fester in the background, but earnings should be able to burn through that negativity, at least for a while.
Key earnings will continue to roll out in the coming week, and they should help boost sentiment. Importantly, the weakest area of the stock market, the financials, are mostly finished reporting results.
On Monday, chip makers Broadcom and Texas Instruments (TXN) report. The chip sector has started rebounding from recent lows as earnings have come in strong. Since chips are the building blocks for all things tech, the sector is closely tracked.
Tuesday brings U.S. Steel (X), Amazon.com (AMZN) and 3M (MMM). While Amazon provides a good read on consumer health, 3M, with its large global footprint, should give investors a good sense of the global growth picture.
Wednesday brings Boeing (BA); Thursday, Exxon Mobil (XOM); and Friday, Chevron (CVX) and Merck. The energy companies are expected to report strong numbers, largely due to the rise in oil prices from one year ago.
In the end, stocks are valued based on the money companies make. And U.S. companies seem to be making a lot of dough.
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