Stocks: The Risk No One Is Paying Attention To

Stocks: The Risk No One Is Paying Attention To

Anyone who believes that the stock market isn't worried about the threat of a technical default by the U.S. need only look at today's "relief rally" in response to the offer by House Republicans to extend the debt ceiling through November 22 (in exchange for negotiations on long-term deficit reduction and tax reform -- you give to get, in this town). According to The New York Times, a proposal to increase the debt ceiling could be put to a vote as early as tomorrow.

The market was ecstatic about this progress, sending the S&P 500 and the narrower, price-weighted Dow Jones Industrial Average up 2.2%, awarding stocks their second-best daily performance of the year. Small-cap stocks did even better, as the Russell 2000 Index gained 2.5%.

The relief was also evident in the equity options market, as the cost of hedging stocks plunged. The CBOE Volatility Index declined 15.9%, to close at 16.48. The VIX, Wall Street's "fear index," is calculated from S&P 500 option prices and reflects investor expectations for stock market volatility over the coming 30 days.

Forget Washington -- earnings still matter
Amid all the political brouhaha, is anyone talking about earnings? Alcoa kicked off the third quarter-earnings season on Tuesday, and, according to S&P Dow Jones Indices, the S&P 500's operating profit margin is expected to hit 9.62%, which would set a new record, topping the 9.60% set in the third quarter of 2006. However, another third quarter record - this one already achieved, rather than forecasted -- casts some doubt on the prospect for that record profit margin.

Indeed, in a report published on October 4, data and research provider FactSet, of 109 companies in the index that have issued guidance, 90 issued negative earnings-per-share guidance - the highest number since FactSet began tracking guidance data in 2006. Furthermore, if the percentage of companies issuing negative guidance remains at 83% (90 of 109), that would also be the highest figure on record.

This morning, diagnostic information leader Quest Diagnostics issued guidance on earnings per share and revenues below analysts' estimates. CEO Steve Rusckowski cited a deterioration in revenues "later in the quarter." Supermarket chain Safeway , reporting after the market close, missed the $0.16-per-share consensus earnings estimate for the third quarter by $0.16 and lowered its guidance range for the full year to $0.93 to $1.00, from $1.02 to $1.12.

Still, companies do have one factor in their favor: dreadful baseline numbers. As Barclays Capital Managing Director Barry Knapp, who is more skeptical than the average Wall Street cheerleader-strategist, wrote in a recent research note: "Given decidedly weak third quarter 2012 results, which we believe will prove to be the low point for mid-cycle post crisis earnings growth at roughly zero percent, year-on-year comparisons should be the easiest since 2010."

Nevertheless, he added: "We continue to think that analysts' forward expectations remain too optimistic and we expect the 'beat and lower' trend to continue." Fourth-quarter S&P 500 earnings-per-share estimates have come down almost another 2% since the end of June, for a 5.2% drop from a year ago.

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Fool contributor Alex Dumortier, CFA has no position in any stocks mentioned; you can follow him on Twitter @longrunreturns. The Motley Fool recommends Quest Diagnostics. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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