Bulls Take a Licking, Keep on Ticking

In the blur of a prizefight, it's not always easy to determine whether a boxer who refuses to go down has an iron jaw or is simply punch-drunk.

The stock market of the past few weeks is a bit like that fighter, absorbing punishing combinations of corporate earnings shortfalls, hit-and-miss economic data and renewed stirrings of worry about the European debt drama.

Yet with a loss of around 4% from the September high in the Standard & Poor's 500 index Friday morning's level near 1,400, the major indexes have so far declined the urgent invitations of the bears to hit the canvas. (Consistent with the pattern, major averages ended nearly unchanged Friday, despite another round of disappointing earnings.)

Light Profits

About a third of the 30 companies in the Dow Jones Industrial Average came in undeniably light on some combination of third-quarter profits, revenues and forward guidance, including International Business Machines (IBM), Caterpillar (CAT) and 3M (MMM).

Of course, Amazon (AMZN) and Apple (AAPL), New Economy and stock-market stalwarts, similarly disappointed. The smallest percentage of companies has outdone forecasts in a decade.

The broad weakness in company results has so far failed to cut deeply into stock-market values that have been in rally mode — if not always energetically - most of the time since June.

The past week was set up in several ways as a ripe opportunity to feast on weaker share prices for bearish traders, who've been frustrated by the stock market's resilience in 2012. Busy earnings periods have tended to be challenging for stocks, especially in quarters such as this one when the market was placid heading into reporting season.

With the unimpressive but better-than-feared 2% U.S. GDP growth reported this morning helping to calm the market, does all this imply that the bears didn't make much of their, last best shot to do more damage in the very short term?

Earnings vs. Data

Is the market trying to tell us that the corporate results are backward-looking -- stretching deep into the mid-summer business slowdown -- and less important than the firmer domestic consumer and housing numbers, which could be further supported by easing gasoline prices?

It's too early to conclude this with much conviction. This is an aged bull market dependent on a very mature corporate-profit cycle.

Here are some clues that investors should be tracking to determine whether this bit of market turbulence is due to a passing squall or the start of a more treacherous phase.

Cyclical market sectors. Some portion of the weakness in fundamental growth was clearly anticipated by the market, even if it wasn't fully reflected in published analysts' estimates.

Bellwethers of global growth such as the semiconductor sector and Chinese stocks, as measured respectively by the Market Vectors Semiconductors HOLDRS fund (SMH) and the iShares FTSE China 25 index fund (FXI), were badly lagging the broad market into late September, before the major indexes cracked. They have since stabilized or rebounded a bit, but need to show some sustained strength to instill any confidence that the summer slowdown is giving way to brisker industrial activity.

-Investor sentiment. Professional traders were lulled into a state of relaxation by the market's ability to sidestep the threat of a serious correction in the often-difficult month of September. A few surveys that track what investment pros were thinking betrayed a bit too much bullishness, which is often a warning sign that all the likely buyers are already heavily in the market. This contrasts with polls of individual investors, which have consistently betrayed a steadfast skepticism, and thus has not offered a clear market signal one way or another for some time. (See: On Wall Street, Selling Fear Is Good Business)

The recent market slippage and rise in daily volatility has shaken this confidence and allowed healthier doses of anxiety to invade traders' psyches. The research service www.sentimentrader.com notes that the ratio of trading volume in bearish-leaning "inverse" stock exchange-traded funds to overall market volume has recently surged to levels seen only five times before in the past four years.

In other words, traders playing for more downside are starting to press their bets hard. In the past this level of similar action has preceded or coincided with a stabilizing tape. Like other measures of sentiment, this is showing a buildup in nervousness that, paradoxically, should be encouraging to investors, yet has not reached the threshold of clear panic that often accompanies a low-risk rally signal.

Watch the bond markets. It's encouraging that the current pullback has been almost entirely an equity affair. Credit markets have stayed calm, with corporate-debt spreads hanging tight at quite-strong levels. The Chicago Fed's National Financial Conditions Index, a read on liquidity and confidence in the banking system and capital markets, is at the strongest levels of the year.

This offers the cool comfort that stocks are reacting to cyclical headwinds - the limits of corporate productivity gains, an already-known European recession, a well-understood ebbing of Chinese growth, some delayed capital spending perhaps due to fiscal concerns — and not to the simmering threat of another bout of financial contagion and asset-market meltdown. (See The Era of Uncertainty May Be Drawing to a Close.)

If this is the case, then investors' outsized attention on the election, the fiscal cliff and the Federal Reserve could turn out to be misplaced. The pivotal question for the market is whether an aging bull market, one that has lasted longer in terms of time and appreciation than most, underpinned by profit margins rivaling the highest in decades, still has legs for another run to higher ground.

The bull markets of the 1980s, 1990s and 2000s each faced growth scares that fanned recession worries and pointed up the risks to corporate profit margins which, as now,were near historical peak levels. In each decade, recessions were staved off and stocks caught another tailwind.

Trouble is, there likely would have been cyclical recessions in those earlier decades if not for the steady credit expansion and declining interest rates that allowed consumers and businesses to borrow and spend more. Similarly, those stock bull markets coped with peak profit margins through "financial engineering," i.e. corporate buyouts and mergers, and an excitable IPO market to keep the animal spirits raging.

In the present environment, it doesn't appear we are on the verge of either of these supportive forces emerging in a powerful way, leaving the market to messily re-price stocks and re-set investor expectations with each incoming fundamental blow, all the while trying to determine whether the economy can get its legs back underneath it.