Stocks have been in a deep slump since July 22. Is it a coincidence that earnings season for most companies in the S&P 500 was winding down during this time? As corporate commentary grew quieter, there were fewer fresh positive data points coming to help offset the building global gloom.
As a quick recap, corporate profits remain exceptionally strong, yet the broader macro environment, led by crises in Washington D.C. and Europe, has been brutal. Will this coming earnings season, which kicks off on Monday, Oct. 10, bring the spotlight back into a more positive focus? There are solid reasons for optimism and pessimism. Simply put, continued solid quarterly results, paired with correspondingly bright forward outlooks, can no longer be taken for granted in this shaky global economy. Here are four themes you need to closely monitor before making any further buy or sell decisions.
1. Big vs. small; U.S. vs. global
Even as blue-chips stocks have slumped, small caps have had an even rougher time these past few months. In the past three months, the S&P 500 has slid about 15%, while the Russell 2000 Index, a proxy for small caps, has slid more than 20%. Many small-cap stocks are off 30% or even 40% since the July market rout began.
But this trend may soon reverse itself, so the safe haven provided by large-cap stocks my not prove quite as safe. The S&P 500 is reflective of global economic activity, because blue chips, on an aggregate basis, now derive more than third of sales and profits from foreign markets. This could prove especially troublesome for companies with have a high degree of exposure to Europe, such as Procter & Gamble (NYSE: PG), Coca-Cola (NYSE: KO) and Microsoft (Nasdaq: MSFT). The major European economies appear to be slipping into recession, while the U.S. dollar has rallied against the euro. Taken together, these factors are likely to dampen foreign-sourced profits for many blue chips.
In contrast, smaller companies tend to have much less foreign exposure. Sure, the U.S. economy has been tepid, but recent data points -- such as the Institute of Supply Management (ISM's) manufacturing and service surveys -- have been a little better than many had expected. In addition, the United States still looks better positioned than Europe in terms of a possible slip into recession.
2. Watch the balance sheets
One of the biggest concerns in an economic slowdown is rising inventories and rising accounts receivable. Companies need to plan ahead and build inventory in anticipation of future demand, and if inventories sharply spike quarter-to-quarter as a result of an unexpected slowdown in sales, then chances are profit-sapping markdowns are coming to move the goods. This typically applies to retailers, but may also be a concern for industrial firms like Caterpillar (NYSE: CAT) and Honeywell (NYSE: HON).
In a similar vein, rising accounts receivable as a percentage of quarterly sales can be a huge red flag. This would be an early warning sign that some delinquent customers simply can't pay their bills, and those sales will need to eventually be written off. Companies rarely discuss their balance sheets in quarterly press releases, so you'll have to listen to the conference calls to hear the real truth about what is happening with these key balance sheet metrics.
3. All eyes on the banks
For much of the summer, bank stocks have been taking a beating. Investors have grown concerned that banks such as Citigroup (NYSE: C), Morgan Stanley (NYSE: MS) and JP Morgan (NYSE: JPM) have a significant exposure to the Greek economy, and if the country defaults on its external debt, then U.S. banks will need to take significant write-downs. In response, industry executives such as Citigroup's Vikram Pandit have issued vague statements that exposure to Europe in general -- and Greece in particular -- is a lot less than many fear.
The banks will need to do better. If their stocks are to trade back up to book value, then investors will need to be provided with a lot more detail about how any European write-downs may influence book value. On the coming conference calls, listen closely for a discussion of Europe. If exposure is as limited as these banks have been saying, then a powerful sector rally could ensue.
More broadly, the market simply can't sustain any sort of broader rally unless bank stocks are participating. A flailing bank sector is a serious symbolic headwind for investors who fret about the broader health of the U.S. and global economies. So you'll need to see an "all-clear" from the banks before aggressively buying other sectors you may have been eyeing.
4. "It's (still) the economy, stupid"
No matter how good corporate earnings -- and outlooks -- may prove to be, the economy still needs to do its part. Friday's jobs report (Oct. 7), where 103,000 jobs were created (137,000 when shrinkage in government employment is backed out) was surely a positive data point. Last week also saw decent readings from the ISM's monthly surveys of the manufacturing and service sectors. As along as these types of reports don't deteriorate and spook the markets, earnings results -- and outlooks -- can set the tone for the market in October and into the winter.
Action to Take --> A key reason for the market's deep slump these past weeks is a lack of any positive catalysts. Many stocks are now quite cheap and this week's positive trading sessions highlight the fact that bottom-fishers are starting to wade back in. For the rest of the crowd, a still-robust profit outlook from corporate America may be the catalyst to get stocks moving.
