Investors Beware -- The Stock Market Is About to Hit a Wall

So with all this hubbub about earnings, why am I sounding the warning bells? Simple: Because this quarterly reporting season is just the calm before the storm. In two weeks' time, after the first wave of earnings roll out, the bull market is going to run into a wall.

Stocks Aren't Better, Just Less Bad

You see, earnings have a way of stealing the show. And right now the amazing improvements for most stocks compared with 2009 are masking the fact that things are just less bad. The fact of the matter is that there are still serious problems with our economy. Our unemployment rate is pushing 10%. The housing market is still broken. Consumer spending is still anemic. Federal spending has propped up the economy, but now the government has borrowed to the breaking point. Need I go on?

After the sunshine of a favorable earnings season fades, the cold reality of these major indicators will be crystal clear. And Wall Street will not be happy.

As I have been saying for all of March, there is a market leadership shift underway. Consider that after this earnings surge for Q1, the S&P 500's operating earnings are expected to decelerate rapidly. My calculations show that operating earnings should decline 63.5% from the first quarter, then another 33.2% from the second quarter and an additional 24.9% in the third quarter!

You could say the past is finally catching up to Wall Street and that the era of low expectations is rapidly coming to a close.

In fact, a few companies that have underperformed during the "recovery" have already shown serious weakness in earnings reports that were released in March. FedEx (FDX) released brutal fiscal third-quarter earnings on March 18. Rite Aid (RAD) posted a Q4 loss in the drug store's earnings report on March 31. In almost every sector, you can find a blue chip stock that isn't participating in the rally despite the market's low earnings expectations.

Once Wall Street starts raising the bar, reports like those from FDX and RAD may become the norm.

Fuzzy Math

So how did we get here? Part of it was investors' heartfelt desire to believe that the worst is over -- and it is! But the fact is that traders have been using fuzzy math as proof that the bulls are here to stay instead of following the facts.

Technically the average fourth-quarter earnings for the S&P back in 2008 were actually negative given the economic meltdown, so positive earnings over negative earnings generated results that were off the chart -- with some of the best small-cap stocks literally seeing earnings jump by 1,000% over the year-ago-period!

But simply put, if a stock goes from losing $1 million in December 2008 to making a profit of $1 million in 2009, it's not realistic to say the company is growing at a 200% annual rate ... but many investors said that anyway.

Similarly, first-quarter numbers were cheered as sign of continued improvement. Obviously things are much better than when the market hit its 12 year low on March 9, 2009, but does that mean the markets have nowhere to go but up?

The market has been so overwhelmed with wave after wave of strong earnings that this news has overpowered any negative data that previously were hindering the stock market. And I fully expect that to happen again as we kick off first-quarter earnings over the next several days, and it should be a good ride for a week or two.

Bad News For the Market

But the market has been wearing rose-colored glasses and I predict it's about to take them off soon. And when it does, I expect the market to go sideways at best and suffer a significant correction at worst.

This earnings season will be the last time investors can bank on easier year-over-year comparisons. From here on out, the market is going to get much more selective and much more challenging for investors. But here's the silver lining: As the breadth and power of the market shrinks, the very best companies with true sales and earnings growth will see buying pressure and continued share appreciation. This upcoming "flight to quality" will be very good for the handful of elite blue chip companies that are showing real growth and not just fooling the market with fuzzy math, or small cap innovators that are agile enough to capitalize on niche markets.

As the market realigns to favor a small group of companies with elite fundamentals, investors better take notice. Otherwise, you'll find your portfolio left behind.