John Paul Whitefoot writes: Stock markets are only as healthy as their stocks—well, at least they technically should be. But despite its stellar year in 2013, the S&P 500’s component stocks weren’t supporting the growth with strong revenue and earnings growth.

I might sound like a broken record, but the fact of the matter is that the S&P 500 was fuelled by the Federal Reserve and its $85.0-billion-a-month quantitative easing efforts and artificially low interest rates, and the fact that businesses were streamlining operations and implementing aggressive share repurchase programs.

When it comes to financially engineering quarterly results, companies on the key stock indices logged a record-high for share buyback activity. In fact, in 2013, share buybacks amounted to $460 billion—the highest amount since 2007.

Companies on the S&P 500 embraced cutbacks and share repurchase programs because their earnings were nothing to talk about. Despite a year full of all-time-highs, each quarter, a larger percentage of companies on the S&P 500 revised their earnings guidance lower—a seemingly obvious disconnect.

During the first quarter, 78% of S&P 500 companies revised their earnings lower; 81% did so in the second quarter; and a record 83% of firms offered lower earnings guidance in the third quarter. Not to be outdone, the fourth quarter saw 94% revise their guidance lower. (Source: “Record high number and percentage of S&P 500 companies issuing negative EPS guidance for Q4,” FactSet, January 2, 2014.)

In spite of the earnings disappointment, the S&P 500 continues to march illogically higher. The index might have gained 30% in 2013—but did it come at a cost? To keep growing, stocks actually have to start posting legitimate earnings.

Investors will (finally) not be content with the slight-of-hand cost-cutting measures companies have been using to boost earnings. And investors don’t look like they’ll take just solid returns in stride either. They’ll be looking for strong gains to justify the high valuations stocks have been enjoying over the last couple of years.

Case in point: shares in General Electric Company (NYSE/GE) sold off last Friday despite the company posting higher-than-expected revenue and strong earnings growth. This means that investors felt the results weren’t amazing enough to justify the company’s current levels.

Where will the markets go this week? It’s time for companies on the S&P 500 to wow investors. More than 60 S&P 500 companies are scheduled to release their results during this holiday-shortened trading week. As the week closes out, we’ll have a better feel as to whether or not the index can justify hovering near its record high.

And that might be a tough task. Not only is the U.S. economy perched precariously but so, too, are the major global economies. China and India have both seen their manufacturing bases weaken. Production in Britain is at the same level as it was in July 2013 and Canada’s December purchasing managers index (PMI) declined to its lowest level in 23 months. These are important indicators to take into consideration—especially when you consider that almost half of the firms that make up the S&P 500 generate revenues from outside the U.S.

Investors who think the S&P 500 is fairly valued might want to add an exchange-traded fund (ETF), such as Vanguard S&P 500 ETF (PSX/VOO) or SPDR S&P 500 (NYSE/SPY), to their portfolio. Those who are bearish on the index may want to consider shorting those same ETFs.

This article Weak Q1 Earnings to Finally Trip Up the Illogical S&P 500 was originally published at Daily Gains Letter

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