Schaeffer's Outside the Box Blog
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While the media is focused on the perils of the so-called "fiscal cliff" facing politicians in Washington, investors face a much bigger problem heading into 2013. Namely, that the latest earnings-reporting season confirmed a serious revenue slowdown in corporate America is under way. Although the S&P 500 Index (SPX) has recovered the losses since mid-October, another round of profit reports will hit the markets in early January. That, in turn, seems to pose the more significant threat to the recent rally.

No Fear Here

One group of players that doesn't seem particularly worried about the fiscal cliff is index options traders. Overall volume in the SPX options pits has been anemic in recent weeks. Since SPX puts are popular tools among institutional investors for protecting or hedging stock portfolios, the lack of volume seems to reflect a sense of complacency or confidence among many of the "smart money" crowd.

Indeed, the CBOE Volatility Index (VIX) -- which tracks the expected or implied volatility of short-term SPX options -- is mired in the mid-teens and down 16.5% in a little more than a month. The VIX is sometimes called the market's "fear gauge," because it spikes during times when investors get nervous and scared. The relatively low readings from the index, along with the light volumes in the SPX pits, suggest index options traders don't see the fiscal-cliff deadlock as a significant source of event risk in the near term.

Like Dominoes

While a 4.9% gain in the S&P in less than a month has probably eased some anxiety on Wall Street, the upcoming fourth-quarter earnings reporting season could potentially stir up some volatility once again. It's not just what companies say about last year, but their comments about the outlook for 2013 that will probably have the biggest impact.

The third-quarter reports certainly weren't stellar. Total S&P 500 earnings fell 0.9% and, more importantly, revenues declined 1.2%. The fact that profits didn't fall as much as revenues is because companies could improve profit margins to near record levels. Yet, profit margins can only be improved to a certain level. In addition, plenty of companies sounded earnings warnings for the fourth quarter.

Of the Dow 30, 22 stocks saw negative post-earnings reactions after their third-quarter profit reports were released, and only eight saw positive reactions. Indeed, October was a volatile month, as shares of one big-cap name after another fell like dominoes on disappointing guidance. Many have since recovered the losses and more. For example, 3M Co (NYSE:MMM), which dropped 3.8% on Oct. 23 after reporting earnings, is up 4% since that time. The table below shows the top 10 post-earnings losers in the Dow and their subsequent gains and losses since that time. Simply put, if revenue growth is expected to remain low and fiscal-cliff concerns will weaken the economy even further, investors should prepare for another round of volatility when the next earnings reporting season gets underway.

Table of Dow post-earnings losers

The Real Cliffhanger

The floodgates on fourth-quarter earnings won't open until the second half of January, and the media might remain focused on the fiscal-cliff fiasco until that time. Yet, potential tax increases and spending cuts due to the fiscal cliff are likely to take some time to impact the economy and investor psychology. Maybe that's why the VIX remains in the teens and there hasn't been a mad rush to buy puts on the S&P.

The earnings reports, on the other hand, will offer a real-time reality check about the current state of corporate revenues and earnings. If results come up well short of expectations, the market's fall in early 2013 might prove steeper than the fiscal cliff.

As senior analyst for WhatsTrading.com, Fred provides regular notes and daily updates on interesting trading activity and advanced option topics.

Disclaimer: The views represented on this blog are those of the individual authors only, and do not necessarily represent the views of Schaeffer's Investment Research.


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