The Day Ahead: Beware of Paper Champions

It kind of hurt me to hear Clubber Lang call Rocky a "paper champion" in Rocky III. After all, I witnessed America's champ endure all those bloody battles with Apollo Creed in his rise to relevance. I indirectly felt every nose-breaking jab to the face. In my eyes, the Italian Stallion was most certainly not a paper champion -- that is, a superstar who has gotten there by triumphing over unimpressive opponents. The idea is that this person essentially stays on top amid a consistent stream of weak challengers, and the real threats to the throne are kept at bay until some future date.

But I do humbly advise you to beware of "paper champion stock rallies." These one- or two-day advances in the market have the following characteristics.

Speculation increases on a series of positive outcomes well into the distance, with little near-term evidence to support those claims.

Examples: Suddenly, select China data are being linked to express a case for "oversold" areas of the market, such as miners and heavy industrials. Europe's industrial-production figures also bolted on to this logic for added thesis support.

Excessive optimism is thrown the direction of backwards-looking data that could arguably constitute a near-term peak -- which, obviously, we find out later.

Examples: Honest Abe told me that the market needs to cool its jets on extrapolating September retail sales as the best thing since sliced bread -- and ditto on consumer confidence. Each is a reflection of prior advances in housing values and stock prices, and skewed to higher-income households, though I concede mortgage refinances have helped. If you dig deeply, I think you'll find a story of incremental middle-to-low-income financial stress before you detect any knowledge on the range of fiscal-cliff outcomes. My sense is that the average household is still not thinking about the fiscal cliff. It will sneak up on them.

Deep thought on this matter: We'll see an abysmal reaction by most retail stocks to the September retail sales report, as if to proclaim to the masses, "Dude, this stuff is priced in." Of particular concern is the action in Ulta Salon ( ULTA), a retailer of very discretionary products that has basically been a bet on middle-income splurging and replenishment after recession cutbacks. (September's personal-care sales, according to Uncle Sam, was one of the weaker-performing categories).

Paper-champion rallies are built on far-reaching dot-connecting exercises, rather than on appreciation for the litany of real, in-your-face negatives. The core problem is that these rallies have minimal staying power, as the fundamentals will eventually shine through and triumph the suspect logic. What I am dealing with right now is dot-connecting that leads down avenues ending with brick walls. I just can't seem to find that one factor -- or factors -- that triggers a "heck yeah" moment, showing stocks to be a buy as everyone else blatantly sleeps at the wheel.

Honest Abe's Sad-Face List

  • Earnings beats are panned upon further inspection -- for instance, in Citigroup (C). In a true bullish environment, negatives housed inside a company's performance are swept aside amid enthusiasm to jump aboard an apparent fundamentally accelerating-sales-and-earnings story. I sense that, thus far, earnings beats are not causing pops in the shares to the extent they should be, assuming the market is presently oversold.
  • Assuming the bulls are so correct in their macroeconomic assessments, as far as retail is concerned, certain sectors should be vigorously increasing in value -- yet they've fail to do so. If the macro is so incredibly sexy, why not pay a higher multiple on projected future earnings that are indeed misrepresented by current forecasts?
  • We're seeing harsh reactions to harsh earnings revisions, for instance in WD-40 (WDFC). Note that similar companies are tending to trade down in sympathy, but not by enough, in my view. The market is confused as to whether the incident is isolated, and on whether Federal Reserve stimulus will render the future brighter than what appears to be today. Ultimately, this leads to a shock factor when reports or outlooks cross the wires.
  • Bulls are using the month-on-month in September jobs data as support for their opinions. However, it would be wise to pay attention to the ongoing weakness in manufacturing employment, plus workweeks and incomes, as inhibitors to the growth outbreak they so badly desire.

Earnings-Season Quickies

  • The areas of focus for me on Coca-Cola (KO) are sequential volume trends in Europe and whether price increases have continued to stick. Problems in either of these fundamental departments will make me wonder if the search for yield is misguided within consumer staples, and there has to be more respect paid to the deteriorating earnings story, which is pressuring the stock price.
  • Use W. W. Grainger (GWW) as an early guide to industrial earnings season, zeroing in on comments on manufacturing and monthly sales trends. If the bulls are to be believed, Grainger's sales trend will have picked up or remained steady in the last month of the quarter.
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.