A Catalyst Found?

To be sure, Friday's selling was intense as the market experienced its worst day in four months. The media had a field day as stocks sold off hard on the 25th anniversary of the '87 Crash (Was anybody else bothered by the 30-something anchors talking authoritatively about something that occurred when they were in elementary school?). In a fitting tie-in to the historical event, Tech stocks and the NASDAQ were absolutely trashed on Friday and many of the recent leaders finished with big red numbers. And it was important to note that the type of selling we saw to close out the week was uncharacteristic of the action seen over the past three months.

While I would love to blame the selling on the machines that control trading in this day and age and suggest to you that the algos had simply gone haywire just as they did 25 years ago (but that could never happen again, right?), Friday's decline was accompanied by a pretty darn good reason. Up until Friday, the bouts of selling that have occurred during the consolidation phase that has been in place for the past month, lacked a catalyst. I've opined that since mid-September, stocks have been trying to decide whether or not the recent 14.6% run-up in the S&P was overdone.

In my humble opinion, a trading range developed over the past month or so based on this question. When the macro data suggested that things might be weaker than expectations, stocks pulled back. And then the market rallied whenever the outlook for the future appeared brighter. Remember, putting the HFT/algo-induced intraday stuff aside, the stock market remains a discounter of future expectations. And again, since the middle of September, there has not been any obvious catalyst or "trigger" for the moves within the range.

But on Friday, the catalyst was clear. The bottom line is that companies like McDonalds (MCD), Chipotle (CMG), IBM (IBM), Google (GOOG) and General Electric (GE) aren't supposed to report punk numbers. No, these are the names that the bulls have consistently been able to count on to produce strong results, quarter after quarter. But this week, each and every one of these companies missed on one or both of the key earnings numbers (EPS and Revenues) - and some missed badly.

Although I am a card-carrying member of the-glass-is-half-full club and everyone in the game knew that Q3 earnings would be on the punk side, the bottom line is these reports were weaker than expected. While 65% of the companies in the S&P 500 that have reported earnings so far have beaten EPS estimates, only 40% have exceeded the consensus expectations on the revenue side. And unfortunately, this is a problem. Therefore, stocks needed to be "corrected" to the downside to reflect the new reality versus expectations equation. And in this day and age, that corrective process tends to happen rather quickly.

So, where to from here, you ask? For starters, we will see 138 earnings reports from S&P 500 companies in the upcoming week. This means there will be abundant opportunities to either confirm or refute the WTE (weaker than expected) theme that has suddenly developed. Thus, it will be important to pay attention to the revenue numbers and the guidance from the big reports this week. If the WTE theme continues uninterrupted, I wouldn't be surprised to see the current consolidation phase morph into a corrective phase. And in this case, we could see a pullback of 5% or so from the top (which would take the S&P down to 1390ish).

After the earnings parade and the election, the primary driver of the market action going forward will likely be the expectations for the coming two quarters on the economic front (assuming Europe manages to avoid implosion during this time frame, of course). From my perch, I see the issue of the 'Fiscal Cliff' as the real key. If our elected officials can stop acting like pre-schoolers long enough to keep the economy from pulling a "Thelma and Louise," then stocks will likely look ahead to better days and be "just fine, thank you."

However, if the folks in Washington continue the current game of bipartisan political brinkmanship and fail to make any progress on the "Cliff" then a WTE theme is likely to take over at the corner of Broad and Wall. In short, if there is no progress made in Washington then stocks will likely assume that hiring will remain weak, the economy will continue to stumble, and earnings will worsen. And it is a safe bet that the algos will know what to do with that!

So there you have it. In sum, the current consolidation phase could very well turn into a corrective phase if the WTE theme we saw in this week's earnings reports continues. And from there, I believe all eyes will turn to the outlook for the economy going into Q1 next year. Thus, we will need to keep our eyes on the big-picture and stay alert/nimble as it is a safe bet that the ride could be bumpy for a while longer.

Thought for the day... Resolve never to quit, never to give up, no matter what the situation. -Jack Nicklaus

For up to the minute updates on the market's driving forces, Follow Me on Twitter: @StateDave (Twitter is the new Ticker Tape)

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Wishing you green screens and all the best for a great day,

David D. Moenning
Founder and Chief Investment Strategist
StateoftheMarkets.com

Positions in stocks mentioned: none

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The opinions and forecasts expressed are those of David Moenning, founder of StateoftheMarkets.com and may not actually come to pass. Mr. Moenning’s opinions and viewpoints regarding the future of the markets should not be construed as recommendations. The analysis and information in this report and on our website is for informational purposes only. No part of the material presented in this report or on our websites is intended as an investment recommendation or investment advice. Neither the information nor any opinion expressed nor any Portfolio constitutes a solicitation to purchase or sell securities or any investment program. The opinions and forecasts expressed are those of the editors of TopStockPortfolios and may