Braced for Contagion, Poised for Surprises

The powerful stock market reversal and rally that began last week doesn't appear tired yet. Last Wednesday, I wrote about the strength of the reversal and why I was going long through leveraged ETFs like UPRO and TNA, targeting S&P 1,200 at the minimum.

And I also recapped a theme about which catalyst matters more: European debt woes or US economic fundamentals. I proposed that Europe's daily headline knee-jerk would begin to matter less than earnings and leading indicators.

Today's price action might lead one to say, "Hey Kevin, you've got this one completely wrong!" But let's look at what's going on here. The headlines say that the leaders of Germany and France, Angela Merkel and Nicolas Sarkozy, had a little summit over the weekend and emerged with fresh proposals and confidence to stem the crisis.

The Daily European Head-Fake

Did we get specific plans and agreements about Eurozone financial crisis remedies? Nope. We got verbal commitments about recapitalizing banks before the end of the month and the next G-20 summit.

That bodes for a 3% rally in US equities? I don't think so. I think money managers are continuing the same theme as last week -- and the last few months, for that matter -- that the "probable recession" has been well-discounted and the economy and earnings may fare much better than most were expecting.

Since a mild recession was nearly priced-in, what happens to valuations when earnings projections don't fall as much as expected and stocks are on sale? They get really juicy to fund managers, that's what.

The Slow-Growth Overreaction

Yes, the bailout of Belgian bank Dexia was a boost to confidence showing that European financial leaders can actually take action during crisis. I have been saying since mid-August that Europe's implosion (i.e., a systemic banking crisis) would be the tipping point that sent the US into recession. But I guess I have always believed they would do what was necessary, even though they appear to be taking their sweet time.

And, yes, US corporate earnings estimates can still fall below $90 EPS on the S&P 500 this year. But those earnings still put a 13 times P/E multiple on the broad market at an index level of 1,200.

This morning, Zacks Director of Research, Sheraz Mian, offered this evidence of the much-brighter outlook for the US:

In an absolute sense, all recent economic readings have been soft and weak. But relative to fears of a recession, they are pointing towards a non-recessionary outlook. Bottom line: the U.S. economy remains weak, but it does not appear to be double dipping.

Some early evidence of this non-recessionary tone of recent economic reports has started showing up in estimates for third quarter GDP growth rates. On Friday, Macroeconomic Advisors raised their estimate for third quarter GDP growth from 2% to 2.5%, citing the positive economic reports, particularly the construction data, retail sales and payrolls data. I would expect this trend in positive estimate revisions to gain pace in the coming days.

I would add to this that the stage is also set for very positive reactions to earnings and guidance. Not that official expectations are so low, but that mental ones are. Analysts and portfolio managers are "wary of the warnings."

If we don't get them, and we continue to hear "steady as she goes" language from CEOs like we got last week from corporate heads at FedEx (FDX - Analyst Report), General Electric (GE - Analyst Report), and ExxonMobil (XOM - Analyst Report) at a summit in Colombus, Ohio, then stocks will sustain their current forward estimates.

The View from the Chart

The one piece of evidence that still makes me doubt we'll see S&P 1,300 again this year is the chart. Yes, everyone will be cheerleading the fact we made it back through the 50-day moving average, currently sloping down at 1,175.

But I predicted this back in early August as just a natural part of bear market rallies. Now we haven't "officially" entered a bear market since the index barely closed 20% off the peak (19.7% by my rough calculation using 1,370 and 1,100).

Still, the chart doesn't look exactly bullish. It looks like a lot of sideways bull vs. bear energy needs to be exhausted before we can recover the 200-day moving average. That battle and its data digestion could take another four to six months.

And that's with no recession. Just slow growth, especially as China engineers a soft landing. As always, the best investing and trading opportunities will be in playing earnings and technical momentum in quality companies.

Even though energy, materials, and industrials are the most sensitive to the global slowdown, catching the swings in names like CVR Energy (CVI - Snapshot Report), Freeport McMoRan (FCX - Analyst Report), Potash (POT - Analyst Report), and Cummins (CMI - Analyst Report) has paid off recently. These all will likely test their lows again before long and offer another opportunity.

Kevin Cook is a Senior Stock Strategist with Zacks.com

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