The Day Ahead: A Three-Headed-Dog Market

 | Sep 05, 2012 | 8:15 AM EDT
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You have never seen a three-headed dog, and neither have I. They exist only in nightmares, perhaps after a viewing of the 1989 thriller Pet Sematary. But, for argument's sake, let's say a three-headed dog managed to follow you on a walk. Obviously this animal would appear very strange to you, and the freakish creature's heads would be going in every which direction and wearing different facial expressions.

That brings me to Tuesday's market action.

Head No. 1: A strange feeling fell over the crowd that, quite possibly, the European Central Bank will disappoint this week in how it chooses to tackle the debt disease -- and I say "disease," because the word "crisis" implies a short lifespan. This reaction was entirely justifiable, as ECB President Mario Draghi apparently wants three-year bond buys instead of the "buy worthless debt forever approach," which is what the market wanted. (That was never going to happen anyway.) Furthermore, this one particular thought got planted in the market -- one that said the ECB will make no significant moves before Germany votes on the European Stability Mechanism, or bailout plan, next week.

Head No. 2: I'm not sure about you, but I got walloped by sell-side notes that should have been released weeks ago. The underlying theme was that investors should de-risk -- a.k.a. book profits -- for fear of headline letdowns in the wake of key events on the short-term horizon.

Head No. 3: Debbie Downer economic data was initially viewed on a stand-alone basis. In other words, the market recognized that the numbers stank, and that they told a tale of a further slowdown in economic growth in the third and fourth quarters that should transmit to an "earnings recession." Ah, but wait -- the market seemingly forgot that its trusted friend, the Federal Reserve, remains ready, willing and able to provide the juice. After this small fact was brought back into the fold, the intraday rally was able to take form.

Once the market realized that bad U.S. data were actually a good thing, and that the ECB may not completely screw up this meeting, stocks reversed course to a stronger degree. Normally, such a swift reversal from left field is met with a heavy dose of skepticism by yours truly. One would have had to consider that glaring negatives were being weighed back and forth, only to get swept under the rug by the sound of the closing bell.

But, as I indicated Tuesday, trading into the powerful events -- initially, the ECB news -- is worthwhile if you have been tracking the comment trail from key figures in the game in recent weeks. The market's bid Tuesday is a signal that expectations of a central-bank backstop remains alive and kicking, or playable, even as corporate fundamentals are flashing red in an attention-grabbing strobe-light manner. So, provided your stomach is made of cast iron, adhere to the simple instruction I mentioned Tuesday: Let the market, not late-to-the-party strategists, dictate when you should stop trading around core positions and then book profits more broadly.

Honest Abe's Daily Diary

● Look what the market returned to intraday: homebuilders, which had been initially sold after construction-spending data. I reiterate that builders, as opposed to derivatives, are the way to dance in the housing recovery. Hovnanian (HOV) is acting best relative to its peer group.

● I won't be a fan of basic materials or transports until the U.S. and China officially get re-inflated from extraordinary stimulus. CSX (CSX) and Caterpillar (CAT) are prime examples of why you should sit out this sector for now, and ditto for something like the iShares Dow Transportation Average (IYT).

● If you're inclined to dabble in consumer discretionary, it's GNC (GNC) over Vitamin Shoppe (VSI).

● On Decker's Outdoor (DECK), I'm not feeling how its outlook is shaping up on cost of goods sold, nor on what this means to consumers.

Term to Know: Earnings Recession

You will be hearing this term roll off the tongues of strategists shortly, so be aware of it today. An earnings recession is jargon for "earnings per share falling year over year for two consecutive quarters." An economic recession, as we are all aware, is loosely defined as two quarters of negative gross domestic product growth. Excluding the financial sector, U.S. companies are poised for an earnings recession in the current quarter, regardless of whether we see action from the Fed or the ECB. In light of this, it will be tough to sell the idea that stocks will be a buy into year-end.

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