Earnings Outlook Darkens, Adding to Investor Worries

While second-quarter earnings may have been reason to celebrate for many publicly traded companies, their third-quarter outlooks quickly came along to crash the party.

About two-thirds of the companies that make up the Standard & Poor's 500 have beaten Wall Street estimates so far. But many, like Lowe's did on Monday, warned of more difficult times ahead.

Pressures on consumers from a weakening employment picture, the still-slumping housing market, a global economic slowdown and energy prices that, while lower, remain near historic highs place significant headwinds on growth for the rest of the year.

"There's no reason why the consumer spending pattern should change," Macy's CEO Terry Lundgren said on CNBC. "I think we've all sort of backed down a little bit for our expectations for the second half."

The results could be daunting for investors: Lowered company profits translating into another downturn for stocks that will make the summer rally seem more like a head fake than a market bottom.

Trouble Ahead, Trouble  Behind

Reading too much into summer stock movements, when low volume can lead to spurts either way that are not generated by market fundamentals, is always tricky business. But with an economy teetering on a technical recession, the practice can be especially dangerous.

For instance: A slew of retailers, including JCPenney , last week reported mediocre earnings combined with scaled-back forecasts based on consumer weakness. Yet their stock prices jumped, apparently on the belief that the news still wasn't as bad as some might have thought and could be worth jumping into if the economy escapes a full-blown recession.

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"It's a wacky market. It's a very difficult market to trade," says Kathy Boyle, president of Chapin Hill Advisors in New York, and one who has warned for months about a looming sharp downturn in stocks heading deeper into the year.

"I would not believe this rally. I would be very skeptical," she adds. "I think it does have a few more weeks to run, but I would not be buying any retailers thinking they would be a bargain at these prices."

Instead, Boyle advocates a cautious approach to stock-picking and is more closely watching exchange-traded funds that capitalize in downward moves in stock market indexes. In particular, she says she is watching the ProShares UltraShort Real Estate fund that pays twice the inverse of the Dow Jones Real Estate Index. If the fund reaches 80 to 82, she advocates a buy, though she urges caution to average investors looking to play inverse ETFs.

Warnings Abound

Bearish sentiment about the market through the end of the year is hardly an isolated phenomenon.

Citigroup on Monday cut its target for both the S&P and the Dow 5 percent.

Of course, that's the bad news. Citi's projections still have both indexes gaining 12 percent from here to a 13,250 Dow and the S&P up to 1,475, buoyant viewpoints considering the pessimism regarding earnings.

Quincy Krosby, chief investment strategist at The Hartford, says falling oil prices could help mitigate damage done to the consumer by the other economic pressures.

"This is a story of moving parts," Krosby says. "You have oil prices coming down significantly. That will help not just in optimism but it will manifest itself in consumers having more discretionary income.

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"As the consumer does better, you may have Corporate America thinking that the downturn may not be as deep and long-lasting and therefore may not get into the kinds of layoffs that are always associated with a deep downturn."

In the meantime, Krosby likes large multinationals and their steady balance sheets and dividends as a reliable way to navigate a market downturn. And make no mistake, Krosby says a sharp move downward to test the March lows , on at least an interim basis, is a strong possibility for the market.

"You'll see it in the automobiles, you'll see it in the credit markets. The tentacles have spread to all parts of the economy," she says. "It is likely that we may test the bottoms. However, as we do, as we create a new bottom and a new low, valuations are just simply increasingly attractive. Value is being offered up as we go through this bear market."

Look Out Below

Stocks began the latest rally on July 15, which coincided with the Securities and Exchange Commission announcement that it was cracking down on naked short-selling in the financials, particularly government-sponsored mortgage giants Fannie Mae and Freddie Mac .

Since the rule was lifted last week financials have struggled, and Fannie and Freddie both plunged Monday on a report that they would need to be recapitalized at the expense of US taxpayers. For some, that in itself is a sign of danger to come.

"The SEC kind of manufactured this rally," says Rick Pendergraft, market analyst at Investor's Daily Edge.

Pendergraft predicts a demand-driven rise in oil that will reverse the summer stocks rally and send the market lower, at least through the third quarter.

As a safeguard, he is recommending companies that make consumer products that remain in demand in a recessionary climate.

UST and its array of cigarettes and smokeless tobacco is one company he cites as being recession-resistant, while consumer staples such as Coca-Cola also fall into the category.

American Technology is another company he likes based on steady demand for its hazardous waste management services.

Generally speaking, he says investors will have to look very closely at their investment choices.

"After third quarter earnings, do we see a change in consumer behavior? We could see a little bit of recovery," Pendergraft says. "But over the next three months, I would be very cautious."

© 2009 CNBC.com