Watch Out Below If Earnings Disappoint This Week

“Human beings, who are almost unique in having the ability to learn from the experience of others, are also remarkable for their apparent disinclination to do so.” — Douglas Adams

Last Friday’s sharp sell-off could easily be viewed as a result of the lack of commitment investors currently hold towards the equity market. The bad news is that sentiment might be amplified in the coming week if several factors play out towards the negative side of things.

The string of disappointing earnings reports by some big names in the tech sector was more than enough to send the Dow Jones Industrial Average (DJIA) plummeting more than 200 points, wiping out all but 0.1% in profits for the week. The benchmark S&P 500 Index (SPX) shed 1.7% on Friday, though it managed to eke out a 0.3% gain over the same period. The Nasdaq (COMP) bared the brunt of the Bear assault, giving up 2.2% on the day and 1.3% on the week.

What should be noted is that Friday’s sell-off, which started to stabilize over the last few hours of the trading session, began to escalate in the closing minutes. Not particularly a good sign for market health. One might normally expect at least a few bargain hunters to grab some of the big-name stocks that were discounted 2% or more on the day, such as Apple (AAPL) and Google (GOOG). But the Bulls just didn’t see the moment as much of a buying opportunity.

The sharp one-day drop could continue throughout the month of October and beyond, if factors converge in a negative configuration. Such factors would include continued weak earnings reports, ongoing conflict among the eurozone leaders and any indications that the domestic economy is failing to hold onto the recent gains in housing and jobs.

With about 140 of the S&P 500 companies scheduled to report earnings this week, the potential for negative momentum is certainly there. The bar was generally acknowledged by a number of analysts to have been set pretty low this earnings season, in terms of growth and revenue. The fact that some big names failed to clear even the diminished expectations likely was a key contributor to the sell-off. A continuation of disappointing earnings announcements from some more of the key companies could snowball the market to the downside.

On the European side of the equation, last weekend’s crisis-oriented EU summit produced new signs of discord, a slight step backwards from the previous summit, which produced more of a façade of unity than is usual for such occasions. This time, Germany’s Angela Merkel and France’s Francois Hollande butted heads once again over the thorny issue of euro-bonds, as well as Hollande’s push to give the European Central Bank (ECB) a greater degree of unilateral power, particularly in matters such as the creation of a joint treasury with a higher level of borrowing capability.

Wall Street may have been recently lulled by what appeared to be a consensus towards solutions by the eurozone leaders, but it remains clear that no easy answers or quick solutions are to be put into play anytime soon. This, of course, lends itself to increased investor uncertainty, which generally translates to capital exiting from equities.

In addition, should Spain continue to balk at taking the most recent bailout offer of the ECB, due to the imposition of tough controls and conditions that would have to be signed off on by Madrid, the concern level among investors could get ratcheted up, along with the yields of Spanish bonds.

Also in the mix this week will be the latest GDP numbers from the Commerce Department, pending home sales data, and the latest consumer sentiment readings. Though important enough in their own right, it is probable that this domestic economic data will add ballast to whatever direction the corporate earnings announcements end up taking.

In a nutshell, the week may prove to be a crucial one in defining the direction the market takes for the duration of the year. And that’s a nutshell worth watching very, very closely.

What the Periscope Sees

With the recent market action indicating a fair chance of strong movement, it might be a good time to put on a pairs trade, just to hedge your bets.  A good pairs trade limits potential losses, although potential profits are limited as well. It is a trade where the level of risk becomes somewhat easier to define.

Toward that end, ETF Periscope is utilizing Sabrient’s latest ETF rankings, which employs a forward-looking, fundamentals-based, quantitative algorithm to create a bottom-up composite profile of the constituent stocks within the ETF.

The current rankings place the Financial Sector at the top of the list, while assigning the Telecom Sector to the bottom position. So in this case, for a pairs trade, one possibility is to go long IYF (iShares Dow Jones U.S. Financial Sector Index Fund), while shorting IYZ (iShares Dow Jones U.S. Telecommunications Index).

ETF Periscope

Full disclosure:  The author does not personally hold any of the ETFs mentioned in this week’s “What the Periscope Sees.”

Disclaimer: This newsletter is published solely for informational purposes and is not to be construed as advice or a recommendation to specific individuals. Individuals should take into account their personal financial circumstances in acting on any rankings or stock selections provided by Daniel Sckolnik or Sabrient. Neither Daniel Sckolnik nor Sabrient makes any representations that the techniques used in its rankings or selections will result in or guarantee profits in trading. Trading involves risk, including possible loss of principal and other losses, and past performance is no indication of future results.