Trying To Find The Market's Oxygen Mask

Includes: DIA, QQQ, SPY
by: Kevin Flynn, CFA

A funny thing happened on the market's way to Nirvana last week. Stocks were busily ripping off a 45-degree advance on Thursday while traders confidently anticipated a bullish story from the 2-day EU meeting. It was to be either an agreement on a banking supervisor, a mere way station on the way to joint recapitalization, or some type of Spanish rescue. A parlay of both might have finally broken the 1470 ceiling on the S&P 500.

Out of the clear blue Thursday sky, printer RH Donnelly inadvertently filed Google's (NASDAQ:GOOG) third-quarter earnings several hours early. Said numbers being well short of consensus, the stock price plummeted. It was a bizarre twist, reminiscent of Google's ten-minute 50-point loss in 2006, when then-CFO George Reyes intemperately remarked that search growth was "over."

Stock prices have been falling almost without let-up ever since. The EU meetings produced practically nothing but ill-concealed grumbling and dissent. The earnings parade has had a steady drumbeat of disappointment, with misses of one sort or another - usually on sales and/or outlook - from the cyclically heavy Dow Jones Industrials: GE, Microsoft (NASDAQ:MSFT), United Technologies (NYSE:UTX), McDonald's (NYSE:MCD), Dupont (DD), Caterpillar (NYSE:CAT), AT&T (NYSE:T). Gravity may not be the strongest force, but it does tend to get you in the end.

Consistent with our theme of recent weeks, it will take something from Europe to pull the market out of its slide over the coming days. Not the European economy, heaven knows. The EU PMI (purchasing manager index) slid to a 40-month low at 45.8 (50 is neutral), with manufacturing at a softer 45.3 and France at an even softer 44.8 - and that was an improvement. German manufacturing was at 45.7 and the country's IFO business confidence survey fell for the sixth month in a row, to a 2 1/2 year low. The recession has spread to the core, though it may be the fourth quarter is over before it's official.

What is needed for the stock market right now is a bailout or rescue story that can trump earnings. The trading robots are ready to jump on any story that postpones the threat of catastrophic collapse for another day, which is why the European stock markets are up around 10% in a year in which their corporate earnings and economy are plunging, with no grounds for believing that 2013 is about to get any better.

Once again, the markets have been their own enemy in Europe. After the Spanish IBEX market index soared 6% last week on stories of a non-bailout bailout (see last week's column for details), marking a 35% recovery from the summer low, where was the need for a bailout? Its economy may be getting worse, more revenue shortfalls are on the way and regional credit ratings are getting cut, yet investors piled into Spanish bond auctions last week, particularly hedge funds, emboldened by the ECB's seemingly blanket guarantee and more than a little desperate for yield.

The first catch is that Prime Minister Rajoy has to ask for ECB help first. That in turn depends on conditions which the Prime Minister does not want to agree to, particularly if they appear to violate his election pledge of no bailouts. As I pointed out last week, it has the two sides in a kind of surreal, Beckett-like comedy in which all are trying to figure out how much pretense everyone - the ECB, bond markets, stock markets, German parliament and so on - can swallow. Rajoy doesn't want to appear to be hat in hand, implying only a crisis would change his stance.

The second catch is that the only type of bailout story that might conceivably be agreed to in the near future would mean trading in the quick death for a slow one. Another "rescue" would jolt the equity markets higher, but more austerity isn't going to be what fixes Europe: It needs a balance sheet restructuring. In theory it could get there via years of austerity, but the Union will not be able to hold together in the face of a prolonged, self-inflicted depression.

Earnings are likely to continue to weigh on the market, but there are some rebound possibilities floating around for next month. Greece got a pat on the head from its latest series of meetings, and the rumor now is that the country will be granted until 2016 to get to its goal of a 4.5% primary budget surplus in 2014. If it makes it that far, it will doubtless be given an extension until 2018. Absurd as the agreement may sound, it would be a short-term market benefit. Perhaps Spain will cut its non-bailout bailout deal with the ECB, as it is under considerable pressure to do so.

Before we get to that, however, we have to cross the river Styx on Thursday evening. Amazon (NASDAQ:AMZN), and above all Apple (NASDAQ:AAPL) report earnings after the close, and if Apple CEO Tim Cook doesn't produce the right amount for the boatman, it's going to feel like a long day in hell on Friday. If it's any consolation, the recent steep sell-off in the two stocks might insulate them. Apple is down 12% from its high of a month ago, while Amazon has fallen over 10% just in the last week. Sharp declines like that leading into an earnings report typically lead to relief reversals, rather than more sharp drops. Typically.

Even a blow-out report from Apple might not be enough to keep the S&P from revisiting its 200-day exponential moving average, currently at 1373, in the coming days. Stocks are in oversold territory now, but the week definitely has a May-like feel to it, the last time the S&P came crashing down through the 200-day. It's not a law, but when the S&P makes a genuine breach of its 50-day average, as it seems to have now, more often than not it pays a visit to the 200-day, now little more than a couple percent away. Apple will provide either a respite or a definitive cut in the oxygen line.

In this heightened environment, prices will also be highly sensitive to any surprises in Friday's GDP report, being the first estimate of the third quarter. The first estimate of quarterly GDP tends to be big news anyway, and under the current conditions any surprise rates to generate an even bigger reaction. The domestic US economy doesn't appear to be plunging, but it hasn't been roaring, either.

Earlier data, particularly on trade, along with corporate talk about September business conditions suggest an annual rate close to the last quarter (1.3%) plus or minus a tenth or two, but second-quarter revisions were too large and conflicting for me to want to guess at the initial print. The Bureau of Economic Analysis has a way of occasionally pulling outrageously low price deflators out of the air from time to time anyway, flattering the headline print of "real" GDP.

Those two reports - Apple and GDP - should determine whether or not we are currently undergoing a garden-variety five-percent correction (it currently stands at about four percent) or are still gasping for air when we come to next Friday's jobs report. My base case is that the 200-day comes into play before the end of next week, but it's obviously a volatile situation. The week after that brings the US presidential election and a decision on Greece, either of which could reboot the markets in another direction entirely. It's probably a good time to buckle the seat belts and read the little card about oxygen masks, just in case. In general, earnings are not going to be on your side.

Disclosure: I am short AMZN. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I have Apple call positions as of the night of October 24th. I have hedged Amazon positions.