The Day Ahead: Welcome to Heartbreak Hotel

 | Sep 04, 2012 | 8:00 AM EDT
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In the course of your life, you'll probably have roughly four significant relationships. The first will have been in high school, when you'd been too dumb to realize the person you were dating was a jerk. The second will have been in college, the real intense one. Then there is the post-college person for whom you thought marriage was a near-certainty, until some cheating incident surfaces. Then there is relationship four, wherein you put every life experience into practice and settle down with a worthy soul.

Let's zero in on the feelings emanating from relationships one to three, collectively called "tickets to heartbreak hotel." For us market players, we're dealing with the forthcoming Democratic National Convention; an European Central Bank meeting that is supposed to cure all; the lingering stench of the Jackson Hole, Wyo., Fed symposium; musings from German Chancellor Angela Merkel as she tries to get reelected; September stock performance concerns; and the return of the European Union debt watch. Amid all of this, meanwhile, there is something called "third-quarter earnings season."

Yeah, I know, you want to get rich today and retire to the still-cheap Florida condo market, since you've traded the ECB and August jobs report with surgical precision. However, nobody is giving a darn about how third-quarter earnings season is trending thus far. Mr. Market is not paying attention. The bulls are too wrapped up in the short term, and the bears don't want to wager into beta moments on which the masses are just itching to get long.

This general lack of concern is the very reason I need you to begin to build a foundation of thoughts and a plan of attack on third-quarter earnings. Here is the reality, folks: No event in September will reverse negative fundamental trends in the U.S. or EU from the second quarter, which stuck out like a sore thumb. So, theoretically, we could see developments that investors will embrace near-term -- all of which center on easing or alleviating market stress. These, in turn, may propel the market, only to create the type of enthusiasm that could be blindsided by a Mack truck as earnings warnings begin.

The First Playbook: Third-Quarter Earnings Season

  1. Europe, China, U.S. macro scene: The majority of economic reads are worsening vs. the second quarter. This implies another disappointing top-line quarter, especially for multinationals, that hits the bottom line more thoroughly than it did last time around. In other words, cost cuts will only preserve margins so much. Moreover, the true winners become scarcer. In the second quarter, for example, 25% of companies beat on revenue and earnings estimates -- fewer than the 41% in the first quarter. Fewer true winners leads to crushed investor sentiment, with those companies thought to be leaders surprisingly proffering less-than-optimistic stories.
  2. Balance sheet: Those companies with out-of-whack inventory-to-sales ratios -- for example, Tiffany (TIF) -- continue along this path. That should keep margins under wraps and counter market expectations for improved margin visibility by the fourth quarter.
  3. Cheerleading: I sure am hearing cheerleading on the fact that corporate-bond issuance hit a record last month. I say this is a minor red flag, in fact. Companies are trying to secure debt in a yield-hungry environment, given increasing uncertainty into 2013.

The above information is meant for those with longer investing time horizons than a day. Moreover, it has been inspired by my attempt at making a call on Starbucks (SBUX) as the stock recovers a good portion of its earnings-triggered gap-down. (I would not be a Starbucks buyer here; I'm concerned about U.S. traffic trends and exposure to increasingly challenging China and European markets.)

As for the short-termers, I think trading into the ECB gathering and August employment report from a long perspective is the way to go. I am far from thrilled with corporate fundamentals, as there is more to life than cash on the balance sheets. Still, the deal is that -- judging by the tone of recent comments from ECB President Mario Draghi -- action in the central bank is highly likely. Also, the August U.S. employment report is set to be subpar, below 120,000 headline. Should that come to pass, it would solidify the Fed's next course of action -- open-ended bond buys. This is a sentiment-driven call, so be prepared to reverse if the action is unsupportive.

Random Musings

  • Electronic Arts (EA) has caught my eye, with the stock having held at its 25-day moving average. I think, given the strong upside to initial "Madden NFL 13" sales, sell-side earnings estimates will need to be pushed higher. Also, I do believe there is truth to the rumors the company is being spied for a buyout.
  • Morgan Stanley (MS) and Goldman Sachs (GS) shares are acting better than those of JPMorgan Chase (JPM) and Wells Fargo (WFC). Morgan Stanley intrigues me as a play on potential Fed quantitative easing, combined with a potential DNC/Obama disappointment -- since the flip side of that would be Romney's promise of less banking regulation.



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