I’m becoming increasingly convinced that the upcoming earnings season will produce bifurcated results with larger companies generating at or above consensus results while smaller, more US-centric companies come in at or below consensus readings.

In light of the fact that the smaller company stocks have led this rally, it’s fair to assume that any such disappointment will likely result in large stock outperformance for the current quarter and possibly beyond.



This is not to say that stocks will rise. Rather, the odds suggest that stocks are likely to have a sideways to downward fourth quarter, with the larger risk resting on a meaningful divergence (in both economic and stock market performance) between the large-cap issues and their smaller brethren.

The issue at hand is sustainability. The economy needs it, and so do the equity markets.

Since early March, the stock market rally has been driven primarily by fast-money hedge fund types (along with a considerable amount of short covering). This is unsustainable.

Longer-term investors must come into this market, a fact that the fast-money crowd is betting on because the cash from longer-term investment money sitting on the sidelines (in near-zero interest rate money-market funds) is considerable -- more than $3.5 trillion.

The sustainability factor is at play in the real economy as well. Government spending followed by corporate spending (mostly in the form of capital expenditure and inventory rebuild) must be followed by end-user demand -- aka consumer spending.

The end user is always the key to a sustainable economic advance and the single most important underpinning for a rising stock market.

While this morning's economic report showing a modest upside surprise to US consumer spending has no doubt lifted the bulls' spirits, the less-noticed warning regarding consumer spending from the just-published report from the IMF provides the more substantial information.

With credit availability still constricted, deleveraging still underway, and consumer balance sheets still in repair, expecting a robust economic advance and a further equity market rally to emerge out this soup of stress is a concoction only for the most optimistic and most hidebound to formulaic thinking (such as low inflation justifies above average P/Es).

Investment Strategy Implications

I’ve stated for the past several months that a further rallying in the equity markets will be met with further selling in accounts managed by my company to not just maintain the equity exposure but actually lower it.

I now add to this the probability that further selling may result from any signs of technical analysis divergence between the large- and small-cap issues as well as any further deterioration in the price performance of the Chinese stock market.

Therefore, it’s highly likely that accounts managed (which are presently around 85% invested in equities) will be at or below the 80% level in the coming weeks or months.

Then again, more declines -- such as what we're experiencing today thereby producing lower equity values (as a percent of the total portfolio) -- may do the job for me. At that point, the contrarian in me would have to consider buying into the weakness. At least for the very short term.

Being flexible, especially during times of transitional economies and markets, is a valuable portfolio management skill. Like my Walk the Talk article from two weeks ago, this is always easier said than done.