ETF Periscope: Wall Street Lobs Itself a Softball with Low Earnings Expectations

“Think left and think right and think low and think high. Oh, the thinks you can think up if only you try!“  --  Dr. Seuss

To date, July has not been much of a vacation for investors. After experiencing seven losses out of eight sessions so far for the month, it would seem reasonable to just write off July and head to the beach for a bit.

Yet to do so would have meant missing Friday’s nice pop on the equity markets, which showed that Wall Street still considers stocks a viable option as long as the news doesn’t scare the players away.

All it took was some positive earnings announcements from key players in the banking industry, relative quiet on the Eurozone front, and indications from China that more central bank stimulus was on the way for its cooling economy.  This trifecta of circumstances contributed in a big way to helping two of the three major indexes recoup losses incurred during the prior four sessions, while the third regained some ground.

The Dow Jones Industrial Average (DJIA) ended the week up, though just barely, at 0.2%, while the S&P 500 Index (SPX) notched a miniscule 0.1% gain. The Nasdaq Composite Index (COMP) remained in the red, shedding 1% over the course of the week.

As for the coming week, a slew of Q2 earnings reports will be the predominant focus of investor attention, with no less than one-third of the Dow’s constituents scheduled to announce results in the coming week. Additionally, around 80 of the S&P 500 companies will report their earnings. Taken together, there is a huge potential for market impact this week should a clear trend emerge in either direction.

And it might be a reasonable bet to expect that the trend could point towards the upside, at least based on the consensus of analysts that the expectations for earnings and outlooks are skewed extremely low. This potentially sets the stage for a market rally, as it provides companies the opportunity to exceed predictions with only a modicum of recent-quarter success. On the other hand, the downside potential for a sharp drop is limited, at least as far as earnings reports being the driver for a downtrend is concerned.

So far, signs of potential for an earnings-based rally can be spotted. Of the six S&P 500 companies that reported earnings last week, four exceeded the consensus of analyst estimates. This week will determine if the lowball expectations will be met or exceeded by a substantial percentage of the benchmark S&P 500 Index, and if investors decide that the low bar, which essentially is based on the expected decrease in corporate earnings, is in fact a good thing or not.

So perhaps now the question is, should investors hop on an earnings report-based rally, should one indeed occur? Are stocks now at a level that they offer a fundamentally sound place for capital to flow towards?  Bottom line: Will the current “risk-off” environment shift to “risk-on,” and a return by investors to the equities market in a substantial way?

Maybe, if that was the only thing going on in the market right now.

But it isn’t. Attention will also be placed on other areas before making that determination.

On the Eurozone front, it should be noted that a top European Union (EU) official indicated that he doesn’t think the German high courts will prevent the latest revisions to the European Stability Mechanism (ESM) that were made during the recent EU summit. This should help to alleviate the concern of Germany’s chancellor Angela Merkel, who has said that the changes conflicted with the German constitution. Whether this will address investor concerns regarding the deepening sovereign debt crisis remains a different, though related, story.

With so much bad news on the Eurozone front already baked into the mix, investors may begin to see opportunity in the European markets. However, should another round of sour news emerge from across the pond, it could easily upend any U.S. corporate earnings reports, no matter how positive.

A final ingredient in the mix is an appearance on Capitol Hill of the Fed head Ben Bernanke. Though investors are hoping to hear sweet promises by Bernanke of some new form of Q3, the odds are that little will be offered this week, especially in light of the fact that recent notes from the Fed have shown that there remains substantial resistance to additional stimulus. So nothing for now, probably, at least not until the recent Fed gesture, Operation Twist, has had adequate time to register on the economy, if indeed it ends up registering at all.

What the Periscope Sees

There remains a high degree of uncertainty in the market, though it is worth noting that volatility has been down around its ten-week low, based on the VIX. The dollar has proven solid, indicating cash remains the preferred place to park capital, and that a risk-off environment remains.

On a technical note, it appears that the SPX may be finding support at its current 50-day moving average. Its 50-day MA was the level from which Friday’s 20-plus points upward move occurred.

Taken together, it might be worth considering a play on the banking sector, which could take the lead in any serious market rally at this point. KBWB (PowerShares KBW Bank Portfolio) tracks the KBW Index, which is composed of common stocks of national money centers and leading regional banks or thrifts. It is up over 16% YTD.

For those who might lack confidence that the market is really ready to rally, but don’t want to miss out entirely on the party should it end up being thrown, a different play is to pair up a long trade on KBWB with a short one on one of the euro-centric ETFs, such as EZU, which tracks the MSCI EMU Index. EZU provides full exposure to the equity markets that share the euro, and would certainly suffer a strong negative hit in the event that a new wave of bad news were to emerge from the region. EZU is down over 5% for the year to date.

So, for those inclined towards the relative safety of a hedged play: Long KBWB, short EZU.

ETF Periscope

Full disclosure:  The author does not personally hold any of the ETFs mentioned in this week’s “What the Periscope Sees.”

ETF Periscope
daniel / Tag: DJIA, SPX, COMP, KBWB, EZU, Eurozone, ESM, European Stability Mechanism, FED, BERNANKE /