Disappointing Earnings May Be An Opportunity for ETF Investors, But …

The earnings season is in full swing. Most heavy hitters are slated to report earnings this week or next. Rather than overanalyzing the effect of one or two companies, this article looks at the opportunity and risk presented by the long-term earnings picture.

Even before this year’s earnings ritual started, a number of companies spoiled the third quarter earnings season. Intel, Caterpillar, FedEx and many others warned that estimates were too high.

Bloomberg reported that earnings pessimism among U.S. chief execs is the highest since the 2008 meltdown and the Wall Street Journal warns of an “earnings pothole.”

The S&P 500 has rallied as much as 37% since the October 2011 low and the stock rally has become extended. Could a bad earnings season push stocks off the edge?

De-focus On Earnings

Earnings are just one of many forces that drive stocks, in fact I consider them secondary and to some extent a contrarian indicator. Record high Q1 2010, Q1 2011, and Q1 2012 earnings were followed by dismal short-term stock performance so disappointing Q3 2012 earnings don’t automatically translate into falling stock prices.

Seasonality is favorable for most of the remaining year and key technical support for the S&P 500, Dow Jones and even the Nasdaq-100 is holding up. Let’s take a closer look at the S&P 500’s technical picture.

Since June the S&P has been climbing higher within the black parallel trend channel. The S&P’s rally stopped at 1,474.51 on September 14, which was exactly when the upper parallel channel line converged with a decade old resistance line.

Ironically that was just one day after Bernanke promised unlimited QE3. They say don’t fight the Fed, but in this instance the Fed lost to technical resistance. The decline from the September 14 high helped digest overly optimistic sentiment and put the trading odds in favor of going long.

The October 7, Profit Radar Report cautioned of lower prices, but viewed any decline as an opportunity to go long: “A digestive period that draws the S&P to 1,450 and perhaps towards 1,420 seems likely. The highest probability trade is a buy signal triggered by a move below the lower black channel line (around 1,420), followed by a move back above.”

Using trend lines to identify buying or selling opportunities worked like a charm in 2010 and 2011 (trend line breaks were a major contributor to short recommendations in April 2010 and May 2011), but starting in 2012 the S&P delivered a number a fake trend line breaks.

That’s why the above recommendation was to wait for a break below trend line support followed by a move back above before buying. The strategy worked. From here we simply elevate the stop-loss to guarantee a winning trade. We will go short only if the next important support is broken.

Long-term Earnings Message

Even as the economy continues to deteriorate, corporate earnings have slowly crept to new all-time highs. That’s right, all-time record highs.

The chart below plots operating earnings for S&P 500 companies (as reported by Standard & Poor’s) against the S&P 500 Index. Corporate earnings are the epitome of a mean reverting indicator and as predictable as a boomerang.

Every time corporate earnings get too high they reverse and the boomerang hits stocks. Nobody knows how high is too high. Right now, too many are expecting the boomerang to hit so it may take a bit longer, but we’re getting there.

Summary

Over the short-term (possibly into Q1 or Q2 2013) stocks may continue to rally (despite disappointing Q3 2012 earnings), but the long-term implications of record high earnings are deeply bearish for stocks.

The short-term opportunity for investors is to buy the SPDR S&P 500 ETF (SPY) on pullbacks (as long as they remain above key support). I don’t have a specific up side price target, but we’ll take profits when we see bearish technical divergences.

Concurrently we’ll be watching for a market top. Unfortunately, market tops aren’t a one-time event, it’s a process. Like knocking over a Coke machine, you have to rock it back and forth a few times before it falls over.

We’ll be looking at ETFs like the Short S&P 500 ProShares (SH) and UltraShort S&P 500 ProShares (SDS) once we see bearish divergences confirmed by sentiment and seasonality.

The Profit Radar Report will identify low-risk and high probability buying opportunities when they present themselves.

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Week Ahead for the S&P 500 – QE3 vs. Worst Week of the Year

Last Friday was triple witching and the week after triple witching is notoriously bearish. How bearish? The S&P 500 Index has closed down 22 out of 26 weeks since 1990 (82%) with average maximum losses about 5x as high as average maximum gains.

Historically short sellers of stocks have an 82% chance of making money this week. However, the S&P 500 Index failed to registered a bearish price/RSI divergence at its September 14 recover high.

All recent highs that were followed by a decline of around 10% or more were foreshadowed by a bearish RSI divergence (I use a unique RSI setting to spot divergences – see chart below). So even a bearish outcome this week would likely be followed by higher prices later on.

The purpose of the Profit Radar Report is to identify high probability trading opportunities. With the conflict between bullish technicals and bearish seasonality, there obviously is no high probability set up right now.

One of two things will have to happen to create a better set up:

1)   Prices decline to trend line support to present a possible buying opportunity.

2)   Prices spike quickly to a new high accompanied by a bearish price/RSI divergence to set up a possible shorting opportunity.

Non-leveraged ETFs that can be used to trade the above set up are the S&P 500 SPDR (SPY) and Short S&P 500 ProShares (SH).  Leveraged options include the Ultra S&P 500 ProShares (SSO) and UltraShort S&P 500 ProShares (SDS).

An early tip off to the next developing set up may be a developing triangle. A break out above or below triangle support/resistance should give us a measured target, which may quite possibly set up an even better opportunity than the actual triangle.

Continuous updates and trading opportunities are provided via the Profit Radar Report.