Will The Bottom Hold? It Comes Down To Earnings

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 |  Includes: AAPL, DIA, ORCL, QQQ, SPY
by: James A. Kostohryz

In my recent article, “What Can Go Right For Stocks?” I posited four factors that could help stocks to the upside.

1. Proactive European policy.

2. Proactive Fed policy.

3. Super-committee surprise.

4. Improving consumer and business sentiment.

Since this article was published, we can pretty much cross factors 2 through 4 off of the list right now.

First, the Fed balked at taking decisive stimulative action. Instead, it has embarked on a policy that will not stimulate growth while at the same time eroding confidence in the USD. That would seem hard to do, but the Fed has figured out a way.

Second, acrimony is rising in Washington and the prospects for a positive outcome out of the Super-committee process seem to be becoming more remote all the time. Just yesterday, the U.S. Congress entered a petty deadlock that threatens a government shut-down by September 30, 2011.

Third, with the current configuration of economic and political factors there seems to be no basis whatsoever to expect improved business and consumer sentiment. All signs point to continued deterioration in the weeks ahead.

Finally, pro-active European policy action is still a wild-card possibility. But it seems like a rather remote one. The Germans and various other EU members seem to want nothing to do with further bail-outs or stimulus. Austerity seems is all the rage on the old continent. It is too bad that the Europeans have caught this fever at exactly the wrong time. The time for austerity is during economic expansions, not during a recession. Far from expecting decisiveness, it is far more reasonable to expect that the current tendency of agonizing indecisiveness will continue.

Having said all of that, the market has already absorbed a great deal of bad news on these fronts. For this reason, failures in these areas will not necessarily cause the market to break recent lows at around the 1,100 level on the S&P 500 (^SPX).

Earnings Could Prove Decisive

For reasons outlined here and here, I believe that third quarter earnings could disappoint. I am particularly concerned about fourth quarter guidance.

Sure, many individual companies like Apple (NASDAQ:AAPL) and Oracle (NYSE:ORCL) that are gaining market share in their segments will do great. There are always companies that can buck the primary economic trend. But by definition, not everybody can gain market share at the same time.

The issue is whether a substantial number of companies start sensing a softening of aggregate global demand and communicate this to investors in the conference calls.

Furthermore, rising producer prices (PPI) raises the specter of margin compression. This could represent an even bigger hit to earnings than waning volume growth.

Productivity growth is also of some concern with regard to profit margins. Contrary to what other analysts have written, slowing productivity growth seems to be lagging rather than a leading indicator of margin compression. Having said that, to the extent that the recent productivity data suggest any type of underlying trend, it is certainly not bullish for profit margins.

Conclusion

The Fed will essentially be “out of action” for the next few weeks. Thus the market (^SPX, ^DJIA, ^IXIC, ^NDX) will be “on its own” and without a crutch. In the absence of dramatic action from European officials, corporate earnings should dominate financial headlines.

Investors have been incredibly spoiled over the course of the past two years in regard to corporate earnings. For this reason, I believe that the current earnings reporting period presents more potential downside that upside.

In particular earnings disappointments could be the catalyst that could cause stocks (SPY, DIA, QQQ) to break their recent range with a bottom at around 1,100 on the S&P 500. My downside target of 950-1,020 would then be in play.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Additional disclosure: I am short TLT and long TBT and SBND.