The deterioration in the economy has been clear in recent months, but the equity markets have confounded many investors. Stocks are just 10.6% off their highs and have shown some remarkable resilience, particularly in the last few weeks. There’s a great tug-of-war going on underneath what appears like a potentially frightening macro picture.
A closer look shows that what we’ve primarily seen is deterioration in the macro outlook and not so much in specific corporate outlooks. Despite the persistently weak economy, earnings aren’t falling out of bed. Without a sharp decline in earnings there is unlikely to be a sharp decline in the equity markets (outside of some exogenous event such as a sovereign default).
The most distinct characteristic I can recall from the the 2007/2008 market downturn was the persistent deterioration in earnings. Like dominoes we saw the various industries go down one by one: housing, then banks, then consumer discretionary and on down the line. While the macro picture has deteriorated recently we haven’t seen the same sort of deterioration in earnings that we saw in 2007 and 2008.
In a recent strategy note JP Morgan elaborated on the divergence between the macro outlook and the earnings outlook:
“What matters for equities is earnings and not GDP growth. US GDP growth projections are being cut, but earnings projections have been little affected so far. Investors and analysts are hoping that, to the extent the soft patch in US GDP growth lasts for only a few quarters and does not spillover to the rest of the world, US companies will be able to protect their revenues and profits. Indeed, this is what happened during 2Q, when US companies were able to deliver strong top line and EPS growth even as US GDP grew at only a 1% pace.
It is a prolonged soft patch that poses the greater threat for corporate earnings and equity markets as it raises the specter of deflation and profit margin contraction. Why is deflation bad for corporate profitability? When nominal interest rates are bounded at zero, a fall in expected inflation causes a rise in real interest rates and the cost of capital, hurting corporate profitability. In addition, nominal wage rigidities mean that deflation reduces output prices by more than input prices putting pressure on corporate profitability. Indeed, the Japanese experience of the 1990s provides an example of the erosion in corporate margins under a deflationary environment.”
BlackRock’s Bob Doll also highlighted this in his latest strategy note:
“To us, one of the more interesting features of the current economic and market landscape has been the continued resilience of the corporate sector in the midst of weak economic data. The growth in corporate profits and the ongoing decline in corporate credit spreads are forecasting economic strength. In fact, corporate profit margins as a percentage of GDP are near 40-year highs. During a normal economic cycle, such levels would encourage companies to spend more on capital expenditures and/or ramp up hiring plans, but most companies have remained reluctant to reduce their cash levels. We have seen some increases in capital spending, but a lower amount than would normally be expected given current profits, and, of course, private sector hiring has remained anemic. Some of this reluctance to spend can be attributed to uncertainty surrounding potential legislative and regulatory changes coming out of Washington, but we believe that we are at a point where companies will need to either accept slower growth levels or begin to put more of their capital to work.”
The ability of US corporations to maintain their bottom lines in the last two years has been remarkable. But this strength in earnings will not persist without a rebound in revenues. As I recently highlighted analysts have become increasingly optimistic about the rebound in corporate profits, however, the sustainability of a margin based recovery is limited without organic revenue growth. My analysis leads me to believe that the macro outlook will remain weak despite recent signs of strength in some reports. Corporations tend to be reactive to the macro outlook which likely means they will keep their cost controls tight and maintain a defensive posture. At the end of the chain is the analysts, who tend to be reactive to what corporations tell them.
The best way to visualize this is with the following image. The macro economy tends to be the leading factor in corporate decisions. This is why we will often see the business cycle peak at the point of rampant exuberance and mass layoffs at the trough in the cycle. Corporations are not always out in front of the business cycle and in fact are usually reactive to the macro environment. When times are good they spend. When times are really good they spend excessively. The opposite goes for the downside.
Analysts are the ultimate lagging factor in the equation. A close study of analyst’s expectations will reveal very close ties to what corporations actually tell them. This generally comes via the form of press releases (when Apple says they’ll earn $1 next quarter 75% of the analyst estimates are near $1 even though Apple ALWAYS beats), but can also come via the form of direct communication with analysts. Corporations understand that the estimates matter a great deal to their stock price performance so they keep communications tight. A growing economy is the perfect environment for wise executives who literally toy with the analysts by continually under promising and overdelivering.
The macro picture has deteriorated in recent months, but it has not collapsed. This has reduced the margin for error in terms of corporate earnings. Toying with the analysts isn’t as easy as it was 6 months ago. Intel and Cisco’s warnings a few weeks ago were likely previews of what will become a trend in the coming two months. If the macro picture continues to deteriorate (which I think there is a fairly high probability of) we will slowly see a deterioration in corporate earnings and a lagging effect at the analyst level. But with a slowly deteriorating macro picture this won’t unravel overnight. While most investors like to wish that this process would occur immediately (the equity markets suffer from a nasty case of A.D.D.) that just isn’t the case.
The global economy is like a battleship moving through rough sees. Right now, I think we’re at a critical juncture where the ship is turning south through rough seas. Deterioration at the macro level is clear, though we are likely to see it play itself out over the course of several quarters. If the macro environment deteriorates more than I presume the earnings picture will have a snowball effect. And of course, the same can be said of a positive macro surprise (with markets reacting positively). While we’re beginning to see cracks in the earnings foundation we are not seeing a full blown collapse as we saw in 2008. The market has been volatile, but it has remained resilient because we just aren’t seeing the weakness in corporate earnings. Persistent macro weakness and a few more earnings seasons will likely change that as corporations move to adjust expectations heading into a more difficult environment and the analysts subsequently play catch-up.
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I think that once again we come to the problems of the analysts and more certainly their objectivity when analysing corporate accounts and macro data.
I realised that when studying for an analyst designation. It’s “easy” for the corporate accountants to trick the analysts. Therefore to avoid playing with their reputation they prefer to think like everybody (or at least being on the average of the estimation). It’s easier to say “I was wrong but everyone was…”. Contrarian analysts are very rare in the financial world…certainly when there is a tight link between the analyst and the investment banking department.
A question about this sentence: “The market has been volatile, but it has remained resilient because we just aren't seeing the weakness in corporate earnings.” Does that mean that earnings estimations will be adapted with a lag therefore leading to a bear market? (based on e.g. DCF model it should put pressure on the down-side – you review the earnings, then it impacts your valuation, etc…) Then might that lead to a change in the asset allocation of most people and again pressuring the interest rates of bonds towards 0% for “protection”? (You will excuse me if I am not clear enough but unfortunately English is not my native language)
Paul
PS: Thanks for the article you post on this website! Really really interesting!!
I think everyone likes to believe that the market is this great forward looking indicator, but what’s really going on is that everyone is basically making huge GUESSES based on the macro outlook. It doesn’t get baked in until we actually see the corporate press releases. So, we can sit here all day and guess about how a certain economic report will influence earnings, but we won’t KNOW until the press release hits the wires. This is why earnings reports result in enormous fluctuations in price. We like to think that Apple’s earnings are priced in, but the reality is that we won’t know how well Apple is really doing until they actually tell us. And if that report surprises one way or the other the market adjusts. So there is this guessing game and a lag effect based on the real reports and how analysts and the market responds….
Does that make sense?
For what it is worth, Minyanville wrote a couple of articles that there was evidence of an “invisible hand” at work, artificially holding up stock prices (I tried to find the articles, they were a couple of quarters months ago). I believe they pieced together how only the Fed. could have the resources to do this.
I’m not an economist or a professional investor, just a common-sense real estate broker. It all seems simple to me. In 2009, pretty much all business spending came to a halt and earnings estimates were lowered substantially. In 2010 businesses spent most of the year rebuilding inventory which made it look like the economy was fine and earnings were growing, since it was easy to hit the lowered estimates. Businesses sold to other businesses to restock inventory.
The problem I see now is that it’s all tied to the consumer, and consumers are broke! This is missed by most of the wall street pundits, investors, and analysts since they are truly out of touch with what’s happening to the average Joe on main street.
For the last 20 years the average consumer followed a vicious cycle. First, keep up with your neighbors by purchasing stuff. Then, refinance your home, pull out some cash and pay off the credit cards. Then run the credit cards up again and often do a second refinance or add a second mortgage, since housing prices were always going up, and pay off the cards again. The problem is that now home equity is fully tapped out and values have decreased. The credit cards are full again and the housing ATM is broken, so consumers have no way to spend like they did. I see it every day in people who want to sell their home but can’t since they owe way more than it’s worth and they have no cash savings at all.
If the average consumer is tapped out and can’t use home equity to go on vacations or to buy cars, flat screens, pay for college, etc., isn’t the US economy doomed? Isn’t the stock market just being held up artificially by the constant stream of automatic 401k money that flows in to mutual funds each month, along with banks that are investing the cheap bailout money they’re receiving from our wonderful government?
FWIW, I think you’re spot on here. Corporate earnings have held up so far first through dramatic cost cutting followed by inventory build. That inventory build is still going on if we are to believe the ISM and rail shipping date, but ultimately, it comes down to final demand, which is the consumer. This is the drum that Rosenberg has been banging for some time now. He’ll prove to be right ultimately, but so far corporations have been able to dance away from that fire by doing all the things they can do without that demand. Maybe the demand will come. Who knows? Maybe we’ll see a burst of hiring that will bring some confidence back. Without employment growth, it’s difficult to see how the end demand will be strong enough to justify current estimated for 2011.
How the market behaves is a totally different animal of course. The economy might be the big aircraft carrier that TPC describes, but the stock market is more like the escort of destroyers and frigates, which can be pretty stomach churning rides in rough sees.
Today is a perfect example. It took the month of August for the market to grind its way from the top end of the trading range to the bottom of the range on a series on undeniably bad economic reports. It has taken THREE days (based on today’s futures) to go from the bottom of the range back to the top of the range. But has anything really changed in a month? On balance, not really. A confusing number from the ISM and an employment rate that got worse, albeit with some positive trends within that number. This is reason for the market to rally more than 6% in 3 days?
“This is missed by most of the wall street pundits, investors, and analysts since they are truly out of touch with what's happening to the average Joe on main street.”
You sure hit the nail on the head with that statement. This group (wall street pundits, investors, and analysts) are completely clueless and desperately need to spend some time in the real world.
Great analysis TPC. The fact that ECRI growth rate has stabilized, even though at a bad -10% recessionary-like level, and not plunged to -20 to -30% that we saw in 2008, confirm your thinking.
What does this mean for my investment, that’s the $10 million question. Purchasing puts on SPY probably won’t work very well here as those puts are expensive and would take a significant fall in order to make money on it once you start losing time value. I have been doing that to pair off my short single stock put positions and that hasn’t worked very well (I use the short stock put premium to buy the SPY puts, hoping my stock selection beats SP500). I have started to cut back on SPY put purchases and start selling short puts on SH (the short SPY ETF) to pair against my short stock put positions, to earn put premium on both sides. IN a range-bound market, even one that is moving lower or higher over time, it should work. It will not work if the market plunges or rise sharply.
Any comment on this approach is appreciated.
I can’t really speak to the validity of any single trading strategy without knowing more about you and your goals, etc. This is a market where you need to get the directional bet correct and that’s incredibly difficult given the volatility.
Give me enough “liquidity” and I’ll keep equities up long enough to sell everything you’ve ever bought over the past 10 years.
The most distinct characteristic I can recall from the the 2007/2008 market downturn was the persistent deterioration in earnings. Like dominoes we saw the various industries go down one by one: housing, then banks, then consumer discretionary and on down the line. While the macro picture has deteriorated recently we haven't seen the same sort of deterioration in earnings that we saw in 2007 and 2008.
Back during 2007-8, the S&P 500 peaked at around 1550. As of yesterday, it was 1090, or about 30% lower than it was then.
The deterioration that you describe is mostly priced into the market, right now. If there is to be a correction, it would take a depression to make the amount of that correction meaningful. Anyone who is waiting for Dow 4000 to buy stocks had better be fond of cash, as they will not be holding any equities in the future.
That 1550 S&P number was driven by fictional earnings from industries and companies that have either disappeared or will never get back to those levels again, and nothing is stepping into that gap to replace those lost earnings. The Dow may not get back to 4000, but 7500 – 8000 is not an unrealistic target. I won’t disagree with you that sitting on a pile of cash is not the smartest thing in the world.
Ah yes. It’s all priced in already. You really think the participants in this market have one damn clue what is coming down the line?
The stock market is populated by a few million chickens running around with their heads cut off chasing gains and running around like schizophrenics. They’re not “pricing in” anything. They’re just guessing what is coming down the line. If it all disappoints the market will move lower. Nothing is “priced in” accurately.
The stock market is populated by a few million chickens running around with their heads cut off chasing gains and running around like schizophrenics. They're not "pricing in" anything.
Markets are neither completely rational nor completely irrational. The ratio of rationality to irrationality varies over time, but there is generally some element of rationality at work.
S&P 1550 was at one extreme, a reflection of heady irrational exuberance. S&P 666 was at the other extreme, reflecting utter panic, and driven by technical moves downward and develeraging. We’ve settled into a range that is quite a bit more reasonable than either extreme. It can correct a bit, but it seems more like a traders’ market (volatile, but generally trending sideways to slightly higher) than it resembling either a pure bull or bear.
For over a year, I’ve been referring to what I believed to be a “square root” economic recovery, and I believe now that we are probably entering the tail of the square root. (Admittedly, I would have expected to happen a couple of quarters from now, rather than today, but timing is always tough…) Once the double dip doesn’t happen, I would expect the market to trend somewhat upward in celebration of the single-dip economy, but it’s still going to be a traders’ market, regardless.
Too many LITTLE BOYS BEARISH (last week AAII= 29%).I said TPC and ALBERT EDWARDS from SGEN WAS IN BAD COMPANY.And that was true.
D,
take it easy. This is not your schoolyard. The mkt jumped because of fundamentals and not only because of psychology. I assure you most of us are grown men or women so leave the caps button off and the chatter for another site. Thanks and nice call.
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