The Day Ahead: A Slowly Decaying Market

In trying to find an object to which I could compare the market, I figured there was nothing better than a slowly decaying corpse: That is, it's still presentable on the outside, but it's disappearing on the inside. As the market enters the week, it's obviously still in the land of green on the year, though it's arrived into the fourth quarter with a whimper. Markets peaked Sept. 14, and suddenly the sky was falling. I wrestled with whether I should go bullish again amid the pullback, but the decision came more quickly than I thought. It's quite dicey to load up on risk after a two-week slow bleed-out, given that the next five days are potentially littered with headline and fundamental death traps that aren't priced into valuations.

Specifically, I am concerned about this: As the president and the Vineyard Vines tie-wearing challenger begin the debate circuit, corporate America will take the opportunity to stick it to slow-as-molasses politicians and create a dust storm known as earnings-warning season. Yes, you read that correctly. Across the country, an earnings-warnings season will give the debaters talking points ahead of a jobs report that, barring a fat finger on the "plus sign" button, promises be another subpar, post-recovery junker. It's likely the report will only add to the negatives the bears are carrying around to sell to weak-hand bulls.

Since I am in favor of preparing for everything, here is what you should be seeking during this currently hypothetical earnings-warning season.

Executive Analysis

"The global economy was weaker than we'd expected." This is the classic table setting for the full-year earnings warning. As that sweet nothing rolls from their tongues, this is where my head will be.

  • "Global economy" does not mean only the U.S., Europe and China. It also includes emerging markets such as India and Brazil -- and, in India, April-to-June growth in India came in at 5.5%, the worst performance in a decade. Meanwhile, Brazil's central bank recently reduced its 2012 growth estimate by a full percentage point.
  • How the "global economic weakness" impacts higher-margin business segments will be vital in offsetting softer growth in more established, less profitable businesses.
  • "Inventory destocking" is one phrase that has often sent chills down my spine. It's a phenomenon that signals customer hesitancy is unlikely to abate in a single quarter, and it usually says reordering is not as robust as the market has been pricing into the company's valuation.
  • I'm on a constant hunt for "hype words" designed to deflect attention from the earnings warning and limp operating performance. Examples include: "outstanding," "stellar," "record," "best ever" and "robust."

Actual Earnings Warning

You will want to watch the depth of the full-year earnings shortfall. By depth, I mean two things: (1) how far the slashing was relative to prior expectations; and (2) how far the reduction was vs. consensus. Massive depth would be a negative surprise, and I would lean toward avoiding that stock on the probable pullback, as this indicates unstable fundamentals. But if the depth is somewhat near Street expectations, and there are pockets of the business wherein profits continue to grow faster than sales -- and the stock is reined in -- that is where opportunities will emerge.

I enter earnings season with a negative short-term mindset -- a very reactionary attitude. Something doesn't sit too well. We're seeing mounting data letdowns, a large macroeconomic risk the market has chosen to ignore -- i.e., the fiscal cliff -- and rose-colored glasses like bottoms-up estimates on 2013. While you sit on the sidelines, start thinking about where the next positive catalyst or "tell" could appear from. That's what I'm doing.

The Bucket Shop Rumor Mill

  • I fully anticipate Bill Ackman to defend JCPenney (JCP) if he's asked about the company's progress at this week's Value Investor Conference. Last time he commented on the company a couple months ago, the stock went on a good run. However, the stock has recently demonstrated a knack for trading on the dreadful fundamentals in store for at least the next six months, so I remain cautious.
  • If David Einhorn is in fact short Lululemon (LULU), the Value Investor Conference is likely where he will show his hand.

The Advanced Investor Lesson: P/E Multiples

An interview in Barron's offered a succinct investing lesson for all you hardcore Ben Graham disciples. Be aware of when to assign a company a price-to-earnings multiple that, due to a fundamental change in the business, is not in keeping with its historical or sector norm. The example given was Delphi ( DLPH), normally a low-P/E business (think 5x to 8x) as a result of its commodity operations. Upon exiting bankruptcy, the company is generally in faster-growing arenas, lacking the exposure to low-margin businesses of yesteryear. As a result, Delphi warrants a higher P/E multiple, with the Barron's interviewee suggesting one of 10x to 13x -- typical for an industrial.
At the time of publication, Sozzi had no positions in the stocks mentioned, although positions may change at any time.

Brian Sozzi is Chief Equities Analyst for NBG Productions. In this capacity, he is responsible for developing independent financial content and actionable stock recommendations (including ratings and price targets) for an institutional and retail investor base. In addition, Sozzi is the Editor in Chief of the "Decoding Wall St." investor education online platform.