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We're only about halfway through the Q2 earnings season, and already, we have had plenty of action with more than a few cross-currents.

Last week we noted how the extremely low sentiment levels helped to ignite a mid-July rally. Weak EPS reports were taken as "not quite as bad as expected" giving the bulls an excuse to put some capital to work - and squeezing short traders in the process.

But over the past week, the reality of the poor economic environment began to sink in. The majority of S&P 500 stocks which have already reported Q2 results beat earnings expectations. But revenue growth has been extremely anemic.

According to Bespoke Investment Group, this is shaping up to be the worst quarter for revenue beats in 10 years - and executives are also lowering guidance as a general rule, in an attempt to set the bar lower for the next few quarters.

Also, on Friday, the European crisis stepped into the foreground as both Spanish and Italian stock markets dropped more than 5%. A number of autonomous regions in Spain indicated that they would need help in refinancing debt, and the Spanish government now expects the economy to shrink by 0.5% next year (versus previous estimates of 0.2% growth).

Traders hit the bids on Friday, unloading risk assets and driving US equities lower. The volatility over the past few weeks underscores the importance of embracing a flexible trading approach.

Last week we were able to capitalize on the bullish side, bagging some nice profits on fertilizer stocks. But as US indices approached resistance, and the macro clouds began lining up, we flipped the script and added bearish exposure.

From the Mercenary Live Feed on Thursday after the close:

We said in a previous comment that the Dow and S&P could touch the top of their ascending channels - or alternively that a "Wile E. Coyote moment" could show up. Now we are seeing a potential mix of both, even as economic data points worsen in the U.S. and Europe…

For this reason we'll be tactically expanding our roster of potential shorts on Friday - and early next week if no immediate drop - to take advantage of a swift, sharp decline if it occurs. This likelihood is not guaranteed, of course - what is? - but if such occurs then then potential for downside follow-through will be excellent.

It is at tactical points of opportunity such as these when you "lock and load"…

So heading into the week, all of our current exposure is on the bearish side. We're still managing risk carefully - with a significant cash allocation. But given the bearish price action, disappointing corporate revenue & guidance, and the deteriorating macro picture, the reward to risk favors increasing short exposure.

Below are a few of the areas that we're looking at this week:

Retail Stocks React to Weak Consumer

It has not been a pleasant earnings season for retail investors. The consumer discretionary sector has seen a number of stocks get crushed after reporting earnings, and valuations are still high enough to allow bearish momentum to accelerate.

Putting the pieces together, it's easy to see how retail stocks could continue to see declines as the weakening economy takes its toll.

This quarter, we are seeing corporations report relatively strong earnings, but on revenues that are shriveling. The only way that corporations can keep profit margins robust is by cutting costs - and that only works for a limited amount of time.

Of course labor is one of the primary areas that companies are cutting to boost profit margins, and last week's jobless claims raised more concerns on the employment front. A vicious circle of job cuts…followed by reduced consumer spending…followed by lower corporate revenues…followed by more cost cutting…has the potential to ignite another US recession and send the market into a tailspin.

US retail sales have now fallen for three months in a row. On Thursday, US jobless claims came in above expectations along with weak factory data. And to finish the week, Chipotle Mexican Grill (NYSE:CMG) disappointed investors by announcing weak same-store-sales.

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The stock fell more than 20% on Friday as traders hit the exits. The pain was felt throughout the restaurant group with Panera Bread (NASDAQ:PNRA) dropping 3.8%, Buffalo Wild Wings (NASDAQ:BWLD) losing 3.5% and Texas Roadhouse Inc. (NASDAQ:TXRH) falling 3.8%.

Restaurant stocks are also under pressure from higher food costs as the US drought worsens. Failed crops and spiking corn and wheat prices will require most restaurants to raise menu prices - even as consumers pull back on spending levels.

Since CMG is a "growth darling" and a name heavily owned by growth-oriented mutual funds, we can expect the majority of dip buyers to step in and snap up shares at such an attractive discount. But after the initial reflex buying, CMG (along with other high growth restaurant concepts) will very likely follow through and continue lower until valuation levels become much cheaper.

Over the next few months there will certainly be a number of attractive short setups in consumer discretionary stocks - and specifically premium-priced restaurant stocks.

Energy On Fire - But Can it be Sustained?

Don't look now, but oil prices have been rebounding and hit new 2-month highs last week. Natural gas prices are also headed higher, having completed a multi-month basing process.

Geopolitical unrest in the Middle East has helped to stem the decline for oil prices, and oil producer stock prices are reacting in turn. In fact, if it weren't for the strength in energy stocks, US markets would have finished in the red last week.

Schlumberger (NYSE:SLB) and Baker Huges (NYSE:BHI) both announced earnings last week and gave strong guidance for future drilling projects. It seems the majority of E&P (Exploration & Production) companies are still willing to drill aggressively - pushing up contract prices for oil services.

But is this strength really sustainable? Sure, the tension in the Middle East is serious - but there's always tension in the Middle East. Meanwhile, the developed world - the part of the globe that actually USES the majority of oil produced - looks more like a deflationary trap every day, with growth petering out and oil demand expectations being trimmed.

Looking at the chart of crude oil, it's encouraging (from the bulls' perspective) to see a sharp price rebound over the last two weeks. But it will be tough for crude prices to break through overhead resistance unless the economic picture improves dramatically.

Sentiment levels also play an important role for crude prices and for energy stocks in the coming weeks…

Drillers and producers have held up well and investor sentiment for this group is relatively bullish. This may be positive in the short-run, but if Middle East tensions ease, or the economic picture for developed markets continues to deteriorate, this sentiment could swing dramatically - leading to a significant price dislocation.

Watch energy stocks carefully over the next few weeks as investors could be setting themselves up for major disappointment.

Corporate Bonds - Stretch for Yield

In a zero interest rate environment, investors with a need for regular income are basically screwed. This isn't an accident, by the way. It's an intentional ploy by policy makers to drive assets further out the risk curve so that capital is invested in more "productive" areas to help stimulate growth.

We can leave the policy discussion for another day, but suffice it to say that investors are scrambling to find opportunities to create income, and they are bidding prices higher (and corresponding yields lower).

Corporate bonds have also performed very well this month - and that's true for both high quality as well as high yield fixed income. The SPDR Lehman High Yield Bond Fund (NYSEARCA:JNK) has rallied back up to a key resistance area on the weekly chart, and the iShares Investment Grade Corporate Bond Fund (NYSEARCA:LQD) has gone parabolic over the last month.

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Building short exposure in high-yield assets can be particularly challenging from a timing perspective because of the negative carry issues. Depending on the yield profile of the asset, the negative carry can be a significant expense, or in the case of treasury securities, that yield can be very minimal.

We're watching the action in corporate bonds carefully with an eye toward establishing a short position to take advantage of any contraction as traders take profits. Of course there is also the possibility of a shift in expectations for yields - particularly if the Fed begins to take a more hawkish view on inflation (not likely, but still worth keeping in mind…)

Heading into the new week, we'll be watching to see how traders react to a number of high profile earnings reports.

The two most widely anticipated reports will be Apple Corp. (NASDAQ:AAPL) which reports Tuesday after the close, and Facebook (NASDAQ:FB) which reports Thursday afternoon. Both stocks look extremely vulnerable to a selloff (based on price patterns), and both carry a lot of weight in terms of investor sentiment. If both stocks can manage to impress investors, we could see the market remain relatively stable and within a predictable trading range. But if either report turns out to be a major disappointment, things could unravel very quickly.

This week promises to be an interesting one with plenty of uncertainty and much at stake.

Trade 'em well this week!

Disclosure: As active traders, authors may have positions long or short in any securities mentioned. Full disclaimer can be found here: http://mercenarytrader.com/legal/

Source: View From The Turret: Unraveling Earnings Season