Stocks Rally on Death of Health-Care Reform

It looks like we can chalk up a victory for the good guys. Stocks soared this week, as Congress gave up trying to enact so-called health-care reform — and the massive new taxes to pay for it — until after their August recess. That means it’s dead.

Last week I wrote that if “it gets rejected, then stocks could move a lot higher once they see that it’s still possible for the government of this country to do the right thing every once in a while.” That’s just what has happened.

Let me remind you what’s a stake here. It’s even worse than I wrote about last week. I said that the “surcharge” tax to finance this government takeover of private medicine would raise the top income tax rate to 45%. That’s bad enough, but what I didn’t mention is that the “surcharge” would affect capital gains taxes, too. The rate on long-term capital gains is now 15%. If Obama’s plan is enacted, it would jump to 25.6%.

I can’t think of a surer way to destroy the stock market — what’s left of it — than to raise taxes on capital gains. Isn’t it already hard enough to make money in stocks?

So don’t be surprised that stocks have taken off on the good news that this particular piece of political madness has been consigned to the dustbin of history where it belongs.

It’s especially good news because there’s more and more evidence that the economy really is coming back to life. It would be a shame to snatch defeat from the jaws of victory.

Most important this week, earnings season is shaping up to be absolutely terrific. Forty percent of the companies that are going to report this season have now done so. On average, earnings have surprised on the upside by 11%. That makes this, at least so far, the best earnings season in more than two years — by a substantial margin.

Let’s take a closer look at this earnings season — what’s hot and what’s not.

The biggest winner is the consumer discretionary sector — 120% above expectations on average, thanks to Ford’s (F) huge upside surprise. To be fair, it was really only a smaller-than-expected loss for Ford. But it was still a surprise in the right direction. And the dollars involved — a $997 million improvement — are quite significant.

In second place is the basic materials sector — with an average upside surprise of 56% above expectations. Here the leader is the mighty Freeport-McMoRan (FCX). And this one is a legit double. Earnings — positive earnings, not a smaller-than-expected loss — came in twice as high as was expected.

A perhaps surprising laggard is the financial sector. It’s in dead last place, with an average upside surprise of only 4%. Yes, there were some spectacular individual surprises in the sector. In fact, Wells Fargo’s (WFC) 71% surprise, worth a tidy $1.176 billion, is so far the biggest single surprise of the season. JPMorgan Chase (JPM), General Electric (GE) and Goldman Sachs (GS) also delivered big wins.

But the problem with the sector is that there were big losers there, too. Citigroup (C) was a disaster, a $2.197 billion flop that was a loss three times worse than expected. Morgan Stanley (MS) and Zions Bancorp (ZION) were also huge losers in the sector.

OK, so the brain-dead banking sector didn’t do so well. Which, by the way, is really only to say that it came in, on average, just as expected. And in a funny way, for the banks that’s actually a wonderful thing. The big problem with the sector over the last two years have been that no one has had any idea what to expect. Their problems were so complex and so enormous, how could a mere securities analyst ever figure it out? Well, apparently this quarter they did. At least on average, the analysts expected exactly what they got.

One element of this earnings season kind of worries me. While earnings outside the financial sector have delivered a nice upside surprise, revenues have not. On average, revenues have come in almost precisely as expected — about 1% lower, actually.

The problem with that is that a company’s profits are a fraction of its revenues. If profits are growing when revenues are not, that means the gains are coming from cost-cutting, not a true expansion of the business. What we really want to see is revenues expanding, so that a company can earn a larger slice of a larger pie. Sadly, that’s not what we’re seeing.

So where do we go from here? The matter of so-called health care “reform” is settled for a while. And earnings season has settled in with a nice upside tone. So what is there that could drive stocks higher at this point?

I don’t really see any fundamentals that can do it. But there is one technical factor. There are a lot of hedge funds that are still on the sidelines, that made a lot of money all the way down in the bear market but failed to call the turn at the bottom in March. They might be getting scared here.

There are lots of retail investors who are out of the market, too. They got shaken out in the horrific bottoms last November, and this January and March. They’re not feeling the kind of performance anxiety that a hedge fund manager is feeling, but they’ve got to be getting a little angry watching the stocks they sold at the bottoms recover so significantly. Maybe they’ll want back in.

So in the short term, stocks might have a little more upside. But my guess is that the rest of the summer will be fairly quiet. We need to digest the considerable gains off the March bottom.

After all we’ve been through the last year or two, quiet might be the best thing. I like it when stocks go up — don’t get me wrong. But getting a little rest here wouldn’t be so bad, either. We deserve it.