Thursday, October 08, 2009

Alcoa and JPM Set the Q3 Lows, Are They Going to Set the Highs in Q4?
Alcoa beat expectations in Q2 and Q3 now. JPM beat analyst expectations in Q2 by 600%. The June
swoon in equities ended on the reporting of AA’s and JPM’s July 8-13 earnings reports for Q2. JPM is a
almost a lock to have another decent quarter. Commingled with JPM’s stellar Q2 earnings was banking
analyst Whitney’s bullish call on the banking sector. Whitney got that call off “just in time.” On July 13
JPM earned 28 cents for Q2. Analysts have raised the expectations bar for Q3 as a result and expect JPM
to report earning 49 cents for Q3 on Wednesday Oct 14. This raised expectation leaves room for JPM to
disappoint investors.

On Thursday October 15, Citi is expected to report losing -0.21 after earning a whopping 0.49 in Q2. Citi
upside surprised analysts sandbagged earnings by 232%. In spite of the Q2 bullish earnings surprise for
Citi, analysts have been busily lowering their earnings expectations bar for Citi in Q3. This makes it easy
for C to underachieve. If they can’t walk over that lowered bar, god help them. Still, any losses would be
bad when measured quarter over quarter or even possibly against the backdrop of the previous day’s
positive earnings from JPM.

GS is also reporting on Thursday October 15. They had record earnings of 4.93 a share in Q2 beating
analysts’ expectations by 39%. Analysts have been raising their earnings estimates for GS over the past 90
days from 2.82 to 4.24, with most of the revisions coming in the last 7 days.

You know, sandwiching C’s crappy earnings in between positive earnings from JPM and GS underscores
one thing: the winners and losers in the financial system. Citi is a failed entity and only belongs in a
socialist financial system, a capitalist system, not so much so. Bank of America will likely add another
sour note to the end of next week. They earned 44 cents in March, 33 cents in June, and now are expected
to lose -0.6 cents in Q3. If BAC’s earnings are below Q2 earnings, BAC will prove to have entered
another earnings contraction/recession since Q1 09. Not so good and a poor way for the stock market to
end the first full week of earnings. Like C, BAC only fits in a socialist banking system. As an aside,
spearheading the effort to end our socialist banking system is FDIC Chair Sheila Bair, who said last night
in NY, bank “resolution authority is clearly at the top of our list. Too big to fail needs to end.” Amen
sister! Say a prayer her prayers are answered from above.

The Arc of Tension

The upcoming earnings season is building an arc of tension which I view as coming on in an anti-
climactic sort of way. These are dull and boring. The offsetting Q3 earnings estimates from the Big Five
financials indicate anti-climactic outcomes.

Digressing again: we roughly know who are going to be the winners and losers in our socialist system.
This is wholly unsatisfying. Instead of the financial system firing on all 5 (JPM, GS, C, BAC, and WFC)
cylinders, two of them are backfiring. That is a bunch of crap that our policymakers built into the system
when they decided to throw a TARP over the mess and pretend that the crap was all gone, that they could
make the problems go away by hiding the toxic securities over on the Fed’s balance sheets, and stuffing
hundreds of billions of taxpayer dollars into the banksters coffers and then let them borrow money for free
at the Fed window so they can make a killing on the yield curve. And that is supposed to be palatable for
public consumption. I think not.

Back again:so, we are going to have a few winners and a few losers in this earnings season and this will be
anti-climactic in a way that is really not very satisfying to either the bulls or the bears.
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Let me explain. At this point, the stock market is so close to new move highs that we have to concede that
new highs on the year are a distinct possibility next week. That means it is possible we will not see a
secondary high form this week as I anticipated before the week began, which would result in a rotation
lower into the Oct 14 retail sales and Oct 16 IP reports for September. Rather, it is possible that positive
expectations from several of the winners are what is keeping the stock market so bid as we enter earnings
season and offsetting the upcoming downside risks that we expect to see from the Sept retail sales, Philly-
Fed and Industrial Production reports.

Keeping and adopting open mind as to the actual outcome: a new move high next week, or a secondary
high this week followed by a correction next week, we note that the strength of the rally off the October
lows is showing a faster rate of change than the rate of change off the September or the August lows.

This is not unusual to see this faster rate of change happening, but it is a bit surprising to see. This rate of
change noted off the October lows is one of the reasons that I am amending some of my potential
expectations or outcomes for the stock market outcomes next week. The other reason is that the earnings

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expectations may be offsetting some of the crappy September economic data coming out next week. What
I am doing is “reading the tape” and at the same time looking at the upcoming economic data and
strategizing different scenarios. The first scenario is a secondary high this week followed by a correction
next week. But that may not be plausible if earnings this week and next offset the bearish economic data
points we know we will get from September retail sales.

Another digression: whether one is a market forecaster, trader, investor, or all three, one must always be
flexible with expected outcomes and by extensions one’s risk management strategies. That is why it is so
crucial to have a very aggressive and defensive risk management approach. “Play great defense,” is what
Paul Tudor Jones coaches. And if he coaches great defense, that is good enough for me.

For example, (most investors and money managers do not do what Tudor does at all) short term traders are
constantly being chased out of the markets whether on the long side or on the short side and having to
adjust their positions until they get it “just right” for their swing or position trades to become decently
profitable. If they do their job well, they didn’t lose any money getting positioned just right. Thinking and
acting like Paul Jones or a local market maker can be one of the keys to success in both investing and
trading. You trade back and forth, in and out, until you get the position on just right for a swing trade,
trend trade, or countertrend trade.

Back to the matters at hand: Let’s assume this secondary high idea does not work. Not a problem, we are
flexible, and we are playing great defense with our risk management, so we don’t get hurt if we are a tad
bearish at the moment up here. So, the market marches up to new highs next week. What should be the
obvious target? It should be the bearish close gap on the weekly SP500 chart at 1102-1108 (pit session
only 1104-1108 on electronic). Incidentally, the 1.41 external retracement is sitting at 1103. That is the
SP500’s favorite external ratio this decade. Last decade it was 1.27.

Now let is consider what happens once the “rush” to new highs is over. I have had several brief
conversations with a SP500 trader in the past few weeks about the remote possibility of an October high.
As the possibility becomes less remote, it is now on the front burner. From his point of view, we could set
the high of the year in October and then have a serious retrenchment in equity prices going into year-end.
This happened on Thursday October 11 2007. We have many other mini-crashes in October as well. The
15% Asian Contagion crash that began on Oct 7 1997 comes readily to mind. We can’t entirely dismiss
the potential for a sharp and sudden break in the stock market from an October high, and we might trade
for that, but I think that moment has passed with the October 2 NFP low.

Nothing But Milk Toast on the Horizon into Year-End

Here is why. From what I can see on the horizon into year-end, stock market participants will be getting
nothing but milk toast from the economic data. If there were going to be gut-wrenching bullet points that
the big boys would have a need to hedge their portfolios against (say for example the monoline insurers
they hedged against in Q4 07) between now and year-end, I’d say a sharp and sudden break could be
possible. A mix of less bad and less good news, into year end, however are merely offsets that cancel the
bearish scenarios out. The see-saw effect of these kind of oscillations points Nor’East on the chart.

For this reason, if we set new move highs on the year next week, the market sells off, but roughly no more
than 4% to 6%. Then it should just continue its grind higher as everyone settles into the reality that this
year the stock market landed on its feet in 2009 and the high frequency trading systems lock up the trade.
We have had plenty of low volatility examples of this in recent years. The correction from Wednesday Oct
15 to Friday Oct 24 2003 is a key consideration, because the summer of 2003 was the beginning of the last
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manufacturing recovery, same as the summer of 2009. If we look in the manufacturing recovery mirror,
we should not be surprised to find some similarities in market behavior around this earning season.

Oct 6 to Oct 25 2004 was another low volatility pullback. Both pullbacks in Oct 2003 and Oct 2004 ended
around the same time, and we should note the potential for a similar pullback to end around Oct 25. A low
volatility end to 2009 is cool with me. I can sure stand to see the markets quiet down a bit into year-end.
Things will pick right back up in the January anyways at the onset of the Q4 earnings season. Because Q4
08 and Q1 09 were the earnings season troughs, the way I see it from October 2009 as that those two
earnings seasons will be friendly to the stock market and will buoy the market in the first half of the year.
Beyond that the risks should begin shifting to the downside, so the bulls may not like the second half of
2010 or 2011.
October 14 Retail Sales and FOMC Minutes
Incidentally, Wednesday Oct 14 is also the Sept retail sales report and it is the release of the Sept 23
FOMC minutes. The high of the year was set on the Sept 23 FOMC meeting when Bernanke announced
mission accomplished, the recession was over. We could see an anti-climactic Redux of that. Further,
some of our better breaks this year seem have followed retail sales reports, specifically June 11 and
August 14.