Will Bad Earnings Sink the Market?

Like it or not, all streaks must come to an end. And projected Q3 corporate earnings growth is expected to be -2.7% and barring any major changes, that means the S&P 500's (^GSPC) incredible streak of 11 consecutive quarters of earnings growth is over.

Caterpillar (NYSE:CAT), FedEx (NYSE:FDX), and McDonald's (NYSE:MCD) along with others have issued warnings about future growth. Yet over the past year, stocks have shrugged off growth concerns. Is this time different? Has the Great Recession finally caught up with the stock market? Can the market (once again) escape undamaged?

Records are Made to be Broken2012 has been a year of record corporate earnings. (We'll put that record into context in a moment) 

Today, forward Q4 earnings estimates for the S&P 500 is now at a high of $112.26, surpassing the July 13th peak of $111.88, and a new record high for the S&P 500 earnings estimate. (Source:ThomsonReuters)

A few things the reader should keep in mind:

1) Regardless of how earnings turn out, the S&P's (NYSEARCA:IVV) trend over the past 12 years is a compressing P/E ratio. In fact, the current forward 12-month P/E ratio of 13 is still below its 10-year average! 2) Despite 20-30% growth off the 2009 bottom, the S&P hasn't traded much over 15x earnings since then. (Even during the 2003-07 rally, the S&P multiple remained at 15x earnings or about even with earnings growth.)

3) All major market tops coincided with record earnings. And the chart below plots the S&P against earnings since 1998. A picture is worth 1,000 words.

>> click here to view larger chart

What about recent economic "improvements?"

More importantly, how does the U.S. economy now compare to its 2007 highs - not the 2009 lows?

- The unemployment rate today is still 75% higher than it was in 2007- U.S. national debt has jumped 86% from $8.6 trillion in January 2007 to more than $16 trillion - The U.S. post office defaulted on a $5.6 billion payment for future retiree health care benefits - 46 million Americans are on food stamps (up 170% since 2000)

The Moral of the Earnings StoryThe world's central banks (in particular the Fed and ECB) have bid up stock prices to near all-time highs. Yet, even without the threat of sovereign debt defaults, stocks crumbled 50%+ from their 2007 highs. Where will stocks end up this time? What happens when countries start defaulting on their debt?

The bottom line is that the downside potential is now larger than at any other time since the Great Depression. While the long-term outlook is grim, it needs to be balanced with a short-term positive bias of Presidential election years and the Fed's monetary stimulus.

However, it is important to view the recent market action in combination with technical indicators. The Fed has been able to "fool" fundamental market forecasting, but not technical indicators. One of those indicators is support/resistance levels. And it's a fact that no rally starts without a break out above resistance and no meltdown starts without a break down below support.

The ETF Profit Strategy Newsletter identifies the key support level that needs to hold to prevent stocks from dropping like a rock and the key resistance level that - once broken - would foreshadow higher prices.

PS: Greece (NYSEARCA:GREK) is still on target for an official debt default and the IMF threatened to stop its financing unless the country's debt can be brought to sustainable levels. Apparently, a debt-to-GDP ratio of 170% doesn't cut it.

Spain is next up and Spain's economy is 4.6x bigger than Greece's. Italy's economy (another fiscal misfit) is 50% bigger than Spain (NYSEARCA:EWP). Spain and Italy's (NYSEARCA:EWI) combined economies are 11x bigger than Greece's.

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