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posted on 10 April 2016

The Week Ahead: Market Moving Earnings Season Is Here

by Jeff Miller, A Dash of Insight

The economic calendar is moderate. Fed Heads are out in force. More significant is the start of "earnings season." There is always speculation about earnings, but this time is special. I expect a focus on the question:

Will earnings spark a break in the trading range for stocks?

Prior Theme Recap

In my last WTWA I predicted a focus on the parade of Fed speakers, with special attention to their apparent economic optimism. That was indeed a recurring subject, highlighted by Thursday's discussion among the current Fed Chair and three predecessors. One of the "Fast Money" participants even used my mixed metaphor (Fed painted itself into a box). Unlike me, he was not smiling when he said it! Doug Short notes that it was the worst week in the last nine, and also that Q1 GDP estimates are now barely positive. See his discussion and context as well as his excellent weekly chart. (With the ever-increasing effects from foreign markets, you should also add Doug's World Markets Weekend Update to your reading list).

SPX-five-day

Doug's update also provides multi-year context. See his full post for more excellent charts and analysis.

We would all like to know the direction of the market in advance. Good luck with that! Second best is planning what to look for and how to react. That is the purpose of considering possible themes for the week ahead. You can make your own predictions in the comments.

This Week's Theme

The economic calendar is moderate. Once again, the Fed participants will be out in force. More importantly, earnings reports begin with Alcoa on Monday and the big banks late in the week. This season might be the most important in recent years. Economic reports reflect only modest growth. The Q1 GDP estimate is plunging.

For equity investors, nothing is more important than earnings and future earnings potential. With stocks in a recent trading range, many wonder whether there is a potential to break out - and in which direction! Options expiration may provide fuel for an explosive move either way. I expect many to be asking:

Can earnings news move stocks out of the trading range?

Background

The earnings story is crucial for stocks. Unlike many who focus on backward or concurrent data, FactSet shows why earnings expectations are important.

forward earnings

To these results one must also add the effect of the P/E multiple.

Viewpoints

The basic themes, moving from bearish to bullish, are as follows:

  • The earnings recession is upon us. Expect an over-valued market to crash.

  • Earnings reports are based completely on financial engineering - ignoring "one-time" charges and expenses for employee options.

  • Earnings reports do not reflect organic growth. Stock buy-backs are but one element of deception.

  • Earnings reports will beat "expectations" but only because these have been maneuvered lower. A lower multiple might be in store.

  • Earnings are a poor indicator. Look instead to revenue, where few companies are doing better.

  • Look carefully for excuses and a weak outlook in the conference calls.

  • Some of the earnings negatives, especially a strong dollar, are less relevant. This will help international companies.

These viewpoints have all been vigorously expressed in recent days, but my sense is that short-term traders are mostly negative on earnings.

As always, I have my own opinion in the conclusion. But first, let us do our regular update of the last week's news and data. Readers, especially those new to this series, will benefit from reading the background information.

Last Week's Data

Each week I break down events into good and bad. Often there is an "ugly" and on rare occasion something really good. My working definition of "good" has two components:

  1. The news is market-friendly. Our personal policy preferences are not relevant for this test. And especially - no politics.

  2. It is better than expectations.

The Good

There was a little good news in a light week for data.

  • Chair Yellen maintained the dovish tone, but still expressed confidence in the economy. This is consistent with the Fed minutes. Our go-to expert, Tim Duy, agrees.

  • ISM non-manufacturing remained positive and also beat expectations.

  • Jobless claims down ticked to 267K, continuing a string of strong results. (Calculated Risk)

WeeklyClaimsApr72016

The Bad

Some of the news was negative.

  • Factory orders fell 1.7%, lower than the prior month, but in line with forecasts.

  • The JOLTs report was viewed negatively by many since job openings were slightly lower. I am more interested in the quit rate, which shows job conditions by measuring voluntary departures. Here is the balanced analysis from New Deal Democrat. Also check out this chart:

blogger-image-526492811

The Ugly

The Panama Papers. The news of how the rich and powerful escape taxation has many dimensions. Expect it to remain in the news. Here are a few current themes:

The most popular tax havens, from Felix Richter via GEI:

chartoftheday_4587_the_most_popular_tax_havens_in_the_panama_papers_n

Banks have a "tail risk" because prosecutors may pounce. (ValueWalk)

This is a big story in the U.S. (Value Walk)

And dismiss the conspiracy theory about the Russians being responsible. (Brookings)

I am leaving out the effects on Presidential politics. More to come, but generally not good.

An Ugly Update

In January I cited the Flint water problem as evidence of infrastructure neglect, suggesting that it was something to monitor. This week we have an update from VOX. I cannot do justice to the interactive chart in my static format. Please check it out to see the threat in your own community. I was surprised at the variation even with small geographical changes. Here is the basic map (click here for interactive map at Vox):

Lead Concentrations

The Silver Bullet

I occasionally give the Silver Bullet award to someone who takes up an unpopular or thankless cause, doing the real work to demonstrate the facts. Think of The Lone Ranger. This week's award goes to Ethan Harris of Bank of America Merrill Lynch (via BI) for refuting the conspiracy theory about central banks and the dollar. Those who have been on the wrong side of the market embrace any way to blame the Fed. This is a breath of fresh air.

It is not the only Fed conspiracy theory, but taking on this one is a start.

Quant Corner

Whether a trader or an investor, you need to understand risk. I monitor many quantitative reports and highlight the best methods in this weekly update. Beginning last week I made some changes in our regular table, separating three different ways of considering risk. For valuation I report the equity risk premium. This is the difference between what we expect stocks to earn in the next twelve months and the return from the ten-year Treasury note. I have found this approach to be an effective method for measuring market perception of stock risk. This is now easier to monitor because of the excellent work of Brian Gilmartin, whose analysis of the Thomson-Reuters data is our principal source for forward earnings.

Our economic risk indicators have not changed.

In our monitoring of market technical risk, I am now using our new model, "Holmes". Holmes is a friendly watchdog in the same tradition as Oscar and Felix, but with a stronger emphasis on asset protection. We have found that the overall market indication is very helpful for those investing or trading individual stocks. The score ranges from 1 to 5, with 5 representing a high warning level. The 2-4 range is acceptable for stock trading, with various levels of caution.

The new approach improves trading results by taking some profits during good times and getting out of the market when technical risk is high. This is not market timing as we normally think of it. It is not an effort to pick tops and bottoms and it does not go short.

Interested readers can get the program description as part of our new package of free reports, including information on risk control and value investing. (Send requests to info at newarc dot com).

In my continuing effort to provide an effective investor summary of the most important economic data I have added Georg Vrba's Business Cycle Index, which we have frequently cited in this space. In contrast to the ECRI "black box" approach, Georg provides a full description of the model and the components.

For more information on each source, check here.

Recent Expert Commentary on Recession Odds and Market Trends

Georg Vrba: provides an array of interesting systems. Check out his site for the full story. We especially like his unemployment rate recession indicator, confirming that there is no recession signal. He gets a similar result with the twenty-week forward look from the Business Cycle Indicator, updated weekly and now part of our featured indicators.

Doug Short: Provides an array of important economic updates including the best charts around. One of these is monitoring the ECRI's business cycle analysis, as his associate Jill Mislinski does in this week's update. She notes that their interpretation is that the business cycle will not turn higher. His Big Four update is the single best visual update of the indicators used in official recession dating. You can see each element and the aggregate, along with a table of the data. The full article is loaded with charts and analysis.

Bob Dieli does a monthly update (subscription required) after the employment report and also a monthly overview analysis. He follows many concurrent indicators to supplement our featured "C Score."

RecessionAlert: A variety of strong quantitative indicators for both economic and market analysis. While we feature the recession analysis, Dwaine also has a number of interesting systems. These include approaches helpful in both economic and market timing. He has been very accurate in helping people to stay on the right side of the market.

Dwaine's RAVI model forecasts 30% upside for 2016. Readers are invited to contrast this with a typical Hussman article and explain why one should be preferred. More on this in articles to come.

w704

Dwaine also has an interesting animated depiction of unemployment by state.

Barry Ritholtz opines that a recession is not imminent and cites the key elements involved in official recession dating. Barry is one of our frequent and favorite sources. I am delighted that he is helping his wide audience understand this conclusion. Since he has been known to read WTWA on occasion, I am also a bit disappointed. We have been all over this theme since mid-2011. Our top recession forecasters have done much better than his lunch pal from the ECRI. Bob Dieli's methods have worked in real time for decades and include all of the points Barry cites. When Barry next visits Chicago I would be delighted to take him to lunch with Bob. I guarantee that all would enjoy the experience, and Barry would get to meet the recession forecaster with the best real-time record.

The Week Ahead

We have a light week for economic data. While I highlight the most important items, you can get an excellent comprehensive listing at Investing.com. You can filter for country, type of report, and other factors.

The "A List" includes the following:

  • Retail sales (W). Will the gas price effect finally show up?

  • Michigan sentiment (F). Important indicator for employment and spending.

  • Initial claims (Th). The best concurrent indicator for employment trends.

  • Industrial production (F). Will be watched for a sign of a manufacturing rebound.

The "B List" includes the following:

  • Fed Beige Book (W). Anecdotal reports from each region will add color for the April meeting.

  • CPI (Th). This will not matter much until we see a few months over a 2% pace, but market participants are watching closely for any uptick.

  • PPI (W). See CPI above.

  • Crude oil inventories (W). Attracting a lot more attention these days.

There is once again a daily diet of FedSpeak. Friday is options expiration, with the potential to amplify big moves during the week.

I am not very interested in the regional indexes. I am very interested in corporate earnings!

How to Use the Weekly Data Updates

In the WTWA series I try to share what I am thinking as I prepare for the coming week. I write each post as if I were speaking directly to one of my clients. Each client is different, so I have six different programs ranging from very conservative bond ladders to very aggressive trading programs. It is not a "one size fits all" approach.

To get the maximum benefit from my updates you need to have a self-assessment of your objectives. Are you most interested in preserving wealth? Or like most of us, do you still need to create wealth? How much risk is right for your temperament and circumstances?

WTWA often suggests a different course of action depending upon your objectives and time frames.

Insight for Traders

We continue both the neutral market forecast, and the bearish lean. Felix is still 100% invested, catching much of the rebound. The more cautious Holmes lightened up a bit this week, reducing to 85% invested. Holmes uses a universe of nearly 1000 stocks, selected mostly by liquidity. Even when the overall market is neutral, there will often be some strong candidates. Holmes holds a maximum of 16 positions at one time. For more information about Felix, I have posted a further description - Meet Felix and Oscar. You can sign up for Felix and Oscar's weekly ratings updates via email to etf at newarc dot com. They appear almost every day at Scutify (follow here). I am trying to figure out a method to share some additional updates from Holmes, our new portfolio watchdog. (You learn more about Holmes by writing to info at newarc dot com.

Peter Brandt raises a topic well known to pros, but a big source of failure for beginners: Position size. He writes as follows:

Professional traders understand that the goal of trading is to make money, not to be right. Making money in the markets requires losses - a lot of losses. Most traders I know are right no more than 40% or 50% of the time - this means they are wrong and take losses on 50% to 60% of their trades. Being wrong is part of trading.

Read the full post to see how to deal with this.

Dr. Brett keeps bringing it, week after week. Improving your trading is not just a matter of learning rules and avoiding mistakes. He suggests a comparison to an athlete who always competed and never prepared.

The mistake I see traders making is that they spend the lion's share of their effort on coming up with the next trades - not on the process of winning. They focus on making money, not on getting better. It would be unthinkable for them to go a full trading day or week without placing a trade, but they think nothing of going a day or week with no concrete work at the self-improvement that is the source of winning.

Insight for Investors

I review the themes here each week and refresh when needed. For investors, as we would expect, the key ideas may stay on the list longer than the updates for traders. Major market declines occur after business cycle peaks, sparked by severely declining earnings. Our methods are focused on limiting this risk. Start with our Tips for Individual Investors and follow the links.

We also have a page summarizing many of the current investor fears. If you read something scary, this is a good place to do some fact checking. Pick a topic and give it a try. Feel free to suggest new topics if your "fear" is not on the list.

Many individual investors will also appreciate our two new free reports on Managing Risk and Value Investing. (Write to info at newarc dot com).

Other Advice

Here is our collection of great investor advice for this week. It was especially difficult to screen for WTWA since there were so many good articles. Please enjoy!

If I had to pick a single most important source for investors to read, it would be David Fabian's commentary on when an investor might need a (new or first) financial advisor. Some people are extremely successful in business and expect that skill to transfer readily to investing. That frequently does not work. The list of warning signs is typical of what I see in new clients, just as it is for the author. The entire list is good, but here are a few great examples:

 You get the majority of your investment advice from CNBC or Fox Business.

 You sell everything on EVERY 7% drop and buy back again at new highs.

 You own 17 large-cap actively managed mutual funds and can't explain why.

 You think owning gold is similar to holding cash.

 Your broker keeps calling about this private REIT with an incredible yield.

 You have a broker.

 You subscribe to 8 different newsletters who all provide conflicting advice, but you do it anyways to stay "diversified".

 You don't want to sell that mutual fund that has sucked for ten years straight because of "tax purposes".

 You own something with a sales load or surrender charge.

 You check Zerohedge and Drudge Report more than Facebook.

Stock Ideas

Apple could hit $150 a share this year. Jack Hough (Barron's) gets the story from two different Wall Street sources who go beyond the regular analysis of low P/E and $38 per share of cash. Hint: Apple is not just selling devices. The multi-platform service business has started.

Chuck Carnevale has another interesting stock screen. This one considers companies with a smaller market cap, a needed portfolio addition for many. This demanding screen generates a list of good ideas. We have already bought one from the list and others are under consideration.

Strategy

Michael Mauboussin explains why, like Babe Ruth, you need to consider magnitude as well as frequency. Please read the entire article, including this comment from Mr. Buffett:

Warren Buffett, undoubtedly one of the 20th century's best investors, says that smarts and talent are like a motor's horsepower, but that the motor's output depends on rationality. "A lot of people start out with a 400-horsepower motor but only get 100 horsepower of output," he said. "It's way better to have a 200-horsepower motor and get it all into output."

Personal Finance

Professional investors and traders have been making Abnormal Returns a daily stop for over ten years. The average investor should make time (even if not able to read AR every day as I do) for a weekly trip on Wednesday. Tadas always has first-rate links for investors in this special edition. There are several great posts, but I especially liked the advice about how to draw down savings during retirement. It is important for so many people.

Another link from this post is our "best investment advice" for the week. Welcome back from vacation, Tadas!

Market Outlook

Joe Fahmy has four reasons to expect Dow 20K this year, a prediction that "no one on Wall Street" is making. Hmmm.

Why is "everyone is miserable" despite the strength of stocks? There is a lot of FOMO (fear of missing out). (Josh Brown)

Watch out for....

Passive bond funds and ETFs. The rules for these funds require passive, cap-weighted investments. This means that energy exposure got higher as more companies sought financing. At this point there is extra risk. Lisa Abramowicz at Bloomberg has a nice explanation, including current risks.

Market Timing

Even those staying in a single mutual fund do worse than the overall fund performance. Why? Attempted market timing. (Morningstar via WSJ).

IF-AC460_VOLATI_9U_20160331125105

Why such big mistakes? Alan Steel's entertaining post offers a good explanation:

The truth has become our best kept secret.

Year after year we're told by the same experts (read: culprits) that the end is nigh, deflation or inflation will be the death of us, the market indicators are bad and the Black Swans are circling.

In early February investors got so nervous thanks to predictions of an impending stock market collapse they sold out billions to rush to bonds and Absolute Return Funds. These have been a herd favourite for the last seven years since the previous "we're doomed" round of predictions kicked off in March 2009....just before the stock markets shot up.

Great Fun

What if some of the most successful investors needed to get funding on Shark Tank? Josh Brown has the witty answer. I can't do justice to it with a quote, so you'll just have to read to see how Bezos, Musk and others might have fared. I am still laughing.

Final Thoughts

Our top sources - Brian Gilmartin and FactSet are always mandatory reading, but especially so during earnings season.

FactSet shows that actual reports almost always beat the expectations at the end of the quarter. (Last quarter was a notable exception). They also show the probable prolonged "earnings recession" with four consecutive losing quarters.

estimate versus actual

Brian Gilmartin is "growing more confident," that this quarter will mark the earnings bottom. Like FactSet, he notes that the energy sector is key, and he thinks the bottom is in there. Brian did extremely well in avoiding the energy decline for his clients, but he is now gradually building up a position. It is probably wise to pay attention!

Oil and Energy Insider agrees with Brian. (Read to the very end). Their "premium" publication is even stronger concerning this conclusion.

My Take

I agree with Brian that we have reached an earnings trough. It might be another quarter before the investment community joins our conclusion.

There is a chance - and perhaps a good one - that this earnings season will do the trick. Analysts always reduce estimates and companies always hurdle the lower bar. This season includes two significant factors, mostly unnoted by the punditry. Over the years I have read thousands of analyst reports. Your best chance occurs when the herd is wrong about something. I especially like it when the analyst loses focus on the company, ignores their firm's economist, and decides to play "amateur economist." Here are the two current factors:

  1. Estimates were built when most non-economists and traders expected that a recession was imminent. We now know that was incorrect.

  2. Estimates included the effects of dollar strengthening. After all, it happened last year, so won't it continue? That has not happened, so it will not be an (increased) drag on Q1 earnings.

If I am right, earnings will beat expectations by a wider margin than usual. We might even see some positive comments on outlook.

I expect a good earnings season.

Because of cherry-picked spinning, investors watching the reports will probably still have a buying opportunity. At least we know what to watch for: dollar effects, no recession, and outlook.

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