Stocks: Five Key Signals for Investors

Have recent gains made stock investors overconfident? Here are five factors that could show the equity rally is losing steam—or gaining strength

By Ben Steverman

Could the big pullback in global equities on Aug. 17 mark a turning point for the stock market? After a 50% advance in the S&P 500 since March, some argue stock investors had gotten too enthusiastic.

Others, however, insist the sell-off was not the end of the bull, but a sign the market was taking a healthy rest and consolidating its recent gains. The S&P 500 fell a total of 3.25% on Aug. 14 and 17, to 979.73.

Whether a new period of volatility is at hand—or stocks resume a steady upward march—remains to be seen; predicting the market's direction is notoriously difficult. Still, there are some things investors should be looking at in the coming weeks to help get a better sense of where things are headed. BusinessWeek asked investing experts what they're watching.

1. China

The resilience of the Chinese economy has helped bolster world markets for several months, as stimulus from China's strong central government bore fruit. Ordered by Beijing to do so, China's banks boosted lending and Chinese businesses stockpiled commodities.

In 2009 through Aug. 4, China's leading stock index, the Shanghai Composite, had advanced a whopping 91%. But since then, the index has slid 17%. On Aug. 17 the index dropped 5.8% to close at 2,879.63.

"The Shanghai Composite has been posting some eye-opening declines," says independent market strategist Doug Peta. "Maybe that's making investors skittish, given that China's stimulus program seemed to be the most successful worldwide."

2. Investors' moods

It's a paradox, but an optimistic investment community is often a bad sign for the stock market. If all or most investors expect further gains, it suggests the stock market could be running out of new buyers.

Bruce Bittles, chief investment strategist at Robert W. Baird, warned in an Aug. 17 note that "indicators of investor sentiment edged closer to extreme optimism last week." Data from Investors Intelligence showed the number of outright bears falling from 26% to 21%, the fewest since the market's peak of October 2007. Another survey, by the American Association of Individual Investors showed bullish investors rising from 50% to 51%.

Not everyone is convinced. Robert Bacarella, portfolio manager at the Monetta Mutual Funds, detects in investors some greater willingness to take a chance on equities. However, most investors haven't forgotten their huge losses in late 2008 and early 2009, Bacarella says. "They are frightened to death to come back into the market."

Improving economic conditions and earnings reports do raise investor expectations. "As things get better, that only raises the bar," Peta says. Many investors still have a lot of cash to invest, but conditions will need to keep improving to continue pushing stocks higher, he says.

3. Earnings

By now more than 90% of the S&P 500 index has reported earnings from the second quarter of 2009. For the most part, results have been better than expected. According to Thomson Reuters (TRI), analysts on Apr. 1 were expecting S&P 500 second-quarter earnings to fall 31.1% from the year before—as of Aug. 17 earnings were down 28%.

As in the aftermath of the first quarter, second-quarter earnings coincided with a stock market rally. Will the third quarter do the same?

For many firms, the third quarter is already half over. But the bulk of results won't start rolling in until Oct. 7, when Alcoa (AA) is expected to kick off earnings season.

In the meantime, investors and analysts are making their bets. Analysts expect third-quarter earnings to fall 20.7%, a number that has barely budged in the last six weeks. Since July 1, however, expectations have jumped for the fourth quarter, with expected growth rising to 291% from 183%. The main driver is the financial sector, which is expected to recover from huge losses in the fourth quarter of 2008.

Business Exchange

Track and share business topics across the Web.