October 22nd, 2013
What We Learned From Last Week And The Next Budget Battle
by Cliff Wachtel, FX Empire
First, we look at what were the main drivers of market sentiment, as depicted by our prime market sentiment barometers, the top global stock indexes.
US closed, stocks subdued on US debt ceiling deadlock. More of the usual reaction markets have shown after the latest deal hopes fade, a pullback but no panic.
That’s partly due to sheer headline fatigue. However there’s a bigger reasons here.
Both EU And US Debt Crisis Negotiations Explained In A Paragraph
The main reason markets remain blasé however, is the understanding that, as before, the drama is being driven by purely political concerns. That guarantees we are assured of a deal, but only at the last possible moment. In other words, both parties want to look tough for their supporters, hence the last minute brinksmanship. Neither party wants to be blamed for doing real damage to the US economy, hence political concerns force both sides to make a deal. It’s the same dynamic that has driven debt crises in both the EU and US since 2010. Unfortunately deals driven by political rather than economic concerns have only produced short term deferrals of hard decisions rather than actual solutions.
Markets mostly solidly up on us deal hopes though no sign of deal yet
Japan up modestly China down hard over 1%, others mixed, European indexes modestly higher on debt deal hopes, US soars on expected imminent debt deal announcement. Fundamentals and earnings, neither of which justifies stocks being at all-time highs, would now become the prime market drivers.
Asian and European indexes were mixed, as delayed reaction to US debt deal (that was expected anyway and had propped up Asia and European stock markets for the prior two days already) was tempered by
- The knowledge that we’ll revisit the same crisis by years’ end
- A new focus on the uninspiring Q3 earnings results for Thursday from the biggest names reporting that day, IBM, Goldman Sachs, and United Health
With all markets now having had at least a day to digest the new US debt ceiling and budget deal, markets returned to focusing on available fundamental data. These came not only from the economic calendar, but from the crucial second week of Q3 earnings announcements. Overall their record has been mixed, but Friday brought good news from the big names that get the most attention.
Asian, European, and US indexes mostly up on better than expected China Growth data, belief in further US taper delays. US stock indexes closed at a record high for the second straight day and had its best week since mid-July as some big name earnings beats added to the good vibes from China data and US taper delay expectations.
However these expectations hurt Japanese stocks a bit Friday, as the expected continued taper weakened the USD, sent the USDJPY lower, and thus Japanese stocks lower. Given Japan’s dependence on exports, and the safe-havenbehavior or the JPY relative to all other currencies (it’s the top ranked safe haven), Japanese stocks have a double reason to fall when the JPY rises:
- The inverse correlation they have because Japanese stocks are risk assets and the Yen is an extreme safe haven
- As an export based economy a strong Yen really does impact their earnings and general economic growth.
Lessons For The Next Budget Battle
For the full details see our special report: Must Know Lessons From The US Budget Battle For Next Time
Key details of the debt deal include:
The deal funds the federal government through Jan. 15 2014 and suspends the nation’s debt limit through Feb. 7. Extraordinary measures could keep all running until sometime into mid-2014, depending on a variety of factors discussed in our special report here.
Continued Sequestration (automatic budget cuts in specific categories of expenses)
Here’s a bullet point listing are the lessons learned for next week and beyond, regarding Washington’s struggle to decide how to balance taxes and spending, present and future sacrifices and benefits (complicated by the fact that decisions are made by politicians whose planning time horizon rarely exceeds that of the next election). You might want to retain it for reference when we likely revisit this same issue sometime in Q1 2014.
Again, see here for the details of each point.
Back To Pre-Debt Ceiling Debate Mode
Now that the US has chosen to buy time at a cost of yet more debt, we return to prior market watching conditions.
- Depending On Continued QE As The Only Way To Sustain The Weak Us Recovery
That means the relevant monthly data reports the Fed is watching will not necessarily be moving markets in their traditional, direct way (if good data, then risk assets and risk currencies (AUD, NZD, CAD, EUR) up, safe haven assets and currencies (JPY, USD, CHF) moving in the opposite way and vice versa. Instead, markets will often be moving with how they think the FED will react to the data. That means:
- Very bad data is bad because QE isn’t helping, so now what do we do?
- Very good data may be seen as bad if it is believed to increase the pace and timing of a Fed reduction of bond buying (QE taper for those who have been out of touch for the past 7 months or so).
- Goldilocks data (not too hot, not too cold) is likely to get the most bullish response because markets get both hope and continued Fed support.
For a full explanation of risk/safety assets and risk currencies, see here and here. To know how to monitor them all in a matter of seconds, see here. You’ll be a much more sophisticated trader or investor once you have these topics down. For a more in-depth explanation, see here or here.
- Scheduling Periodic Debt Debate Uncertainty
Pencil in your calendar: rising uncertainty on US budget round 3 in Q1 2014.
Is The US Budget Battle of 2014 Already Over? Unlikely
The consensus is that the Republicans won’t risk the political damage of being the ones insisting the US attempt to live within its means. We doubt it, though we do believe they will change tactics and message.
What Mix of Tax And Spending? Washington Still Undecided
Much of that is due to a combination of:
- US voters are undecided or insist on spending cuts, but only those that don’t affect themselves
- Washington’s unwillingness to take unpopular stands
Why US Will Continue To Experience Similar Budget Debate Crises
This section adds to and is a variation on the above.
Bullish: Taper Deferred & Ramifications
Again, see here for the details of each point.
EARNINGS: Mediocre, Highlight Importance of Coming Data, QE Speculation
As noted above, earnings provided some key bullish lift for markets on Friday after a mixed performance thus far. What can we expect going forward?
We’ve just completed 2 of the 3 weeks during which earnings season tends to have the most influence on global risk appetite. We already have results from 99 S&P 500 companies that comprise nearly 30% of the index’s total market capitalization. The reporting cycle accelerates next week, with more than 140 companies reporting results. By this time next week the tone will have been set, with most sector leaders having already reported.
If results thus far are indicative, then earnings are unlikely to be the source of any continued uptrend in the main global indexes that define the market’s mood. Key points thus far as of the close of Markets on October 18th:
As expected, little growth, even after the steep cuts in estimates that preceded this reporting season, (which sets up all of the ‘surprise beats’ of these lowball estimates analysts give, both as a payment for access to these companies and as a means of encouraging sell side business. However reporting companies have thus far struggled to meet or beat even these lowballed estimates.
For those 99 S&P 500 companies having reported as of Friday October 18th:
Earnings and Revenues In Line With Expected Stagnation: Total earnings are up +1.0% yoy, with 62.6% beating earnings expectations, with a median surprise of +2.1%. Total revenues are up +2.1%, with 43.4% surpassing revenue expectations with a median surprise of +0.0%.
All Growth From Financial Sector: Total earnings for the 50.6% of the sector’s total market capitalization that have reported are up +14.6%. The sector’s growth momentum has slowed from the last few quarters and industry leaders like J.P. Morgan (JPM) and Goldman Sachs (GS) have disappointed. Excluding Finance, total earnings growth falls in the negative category – down -6.2%. This is weaker performance than both in Q2 and in the 4-quarter average.
The tech sector exemplifies the weakness outside of Finance. Total earnings, for the 33.6% (by the sector’s total market capitalization) of the sector’s firms that have reported are down -20.6% on +2.3% higher revenues. Google’s (GOOG) positive report has thus far been an exception to weak results from the likes of IBM (IBM), Intel (INTC) and others.
Expectations for the four-fifths of the S&P 500 members still to report Q3 results remain low, meaning that most companies should beat them. Typically about two-thirds of the companies beat earnings expectations – as management teams and analysts team up to under-promise and over-deliver. However, beat ratios are running a lower thus far in Q3.
Expectations for Q4 & Beyond Bullish: But unlike the low growth expectations for Q3, consensus estimates for Q4 and beyond represent a material acceleration in the growth pace.
Total earnings growth is expected to increase to +9.5% in Q4 vs. the ~+3.1% growth pace in the first half of the year, and the current expected +0.2% growth in Q3. The actual growth in Q3 will probably be more like the +2.5% to +3% range seen in the first half of 2013.
While guidance has been strongly negative over the last few quarters, if current Q4 expectations hold, then we need to see more companies either guide higher or reaffirm current consensus expectations. The overall guidance thus far in Q3 isn’t that different from recent quarters, as shown by the negative guidance from recent big names like IBM (IBM), Intel (INTC), Yum Brands (YUM), and Family Dollar (FDO). We will know more in the coming weeks, but Q4 estimates remain at risk of significant revisions in the absence of reassuring company guidance.
In the past, markets have shrugged off negative revisions as aggregate earnings estimates that have been coming down for over a year now. However they were depending on QE3 to keep asset prices aloft, rates low, and leave yield seeking investors with few alternatives.
However if we are entering a post-QE world, then it will likely be difficult to overlook negative earnings estimate revisions going forward. How the market responds to negative guidance and the resulting negative revisions will tell us a lot about what to expect going forward.
The key point: as noted above, much depends not just on how how markets interpret data, but rather how they interpret how the Fed interprets that data
China: Q3 Good But Sustainable?
Good China data was a prime bullish market mover Friday, along with earnings markets Friday. Indeed there is a consensus Q3 was good in general for China. GDP, jobs, and income all looked better. However there are multiple voices pointing out that the growth is not only unsustainable but may have already peaked. See here (from Bank America) and here (Nomura) for details
The Bullish: Markets Back At All Time Highs Reflect Legitimate Reasons
- Debt battle deferred, next one In 2014 may not be so bad
- Appointment of dovish Yellin plus weak data suggest a QE 3 extension and market reprieve from a future ‘taper tantrum like we saw this summer, and that taper delay could be a long one
- Earnings: Great Expectations – Mediocre Q3 Results may be outweighed by better Q4,
- No US elections coming
- Stock markets around the world are selling at fair to absurdly cheap valuations, if you use certain specific metrics like dividend yield vs. bond yields. Granted we’re in an era of historically low valuations, but the fact is this condition matters for yield seeking investors and is pushing them into stocks. As we note below, by other metrics stocks look far less appealing.
From Josh Brown here:
- The banks are as highly capitalized as they have ever been.
- Home prices are back to long-term trend and appreciation continues despite recent mortgage slowdown -normalization being the operative word.
- US households reclaimed the 2007 peak in total net worth and have now surpassed it.
- Small and mid-cap stocks are at all-time highs and yet still under-owned by the largest pools of capital in the US – pensions, endowments and insurance companies.
- Going back 110 years, when the Dow has been up in the first half, it’s finished the year strong with gains in the back half 70% of the time.
- Hedge funds are at their highest net short positions since January and have massively trailed every equity benchmark you can think of.
The Bearish: Markets Back Near All Time Highs That Are Not Justified
The best summary of the bearish argument was from Eric Parnell here. Key points:
- Stocks Have Gotten Ahead Of The Economy
- US GDP estimates run between 1.5-2% at best. That 2% is considered a reliable indicator that the economy is stalling and will hit recession – and that’s even with continued QE. IF the Fed decides to taper, it gets worse.
- Sales And Earnings Growth Stalled Over Past Two Years: Yet stocks have advanced despite stagnating earnings and top line revenue that support real earnings growth (vs. earnings via cost cutting and stock buy backs).
As Parnell notes:
we have seen the S&P 500 Index increase by an astounding 464 points, or roughly 37%, in less than a year and a half despite a sluggish economy that included little in the way of sales growth and virtually no earnings growth. This suggests that investors are now willing to pay 37% more today for what is essentially the same stock market they could have bought a little more than a year ago at a much lower price.
Putting this into perspective, would you as a consumer be willing to pay 37% more today for the same television or automobile that you could have purchased a year ago?
- Continued QE No Guarantee of Continued Higher Stock Prices
He then sites a range of assets that had tracked QE growth but then ceased to do so. These included:
- EZ and Emerging Market Stock Indexes
- High Yield Bonds
- Selected Cyclical Stocks
- Industrial commodities like copper and aluminum (granted the China slowdown is a factor here)
- Precious metals like gold and silver (same here)
DISCLOSURE /DISCLAIMER: THE ABOVE IS FOR INFORMATIONAL PURPOSES ONLY, RESPONSIBILITY FOR ALL TRADING OR INVESTING DECISIONS LIES SOLELY WITH THE READER.