The Next Obsession
Markets tend to be a bit obsessive. In recent months, traders shifted from taper-gate to familiar political posturing in Washington, D.C. The next obsession may be earnings. From Yahoo Finance:
By some measures, third quarter earnings season could reflect an unprecedented level of pessimism. According to John Butters, senior earnings analyst at FactSet, nearly one-fifth of companies in the S&P 500 have pre-warned Wall Street that they won’t meet expectations. As a result, the profit growth forecast for the benchmark index has undergone a serious beat down since the start of the quarter, having been cut from 6.5% on July 1st to just 3.0% today.
The Worst Earnings Season Since 2009
If earnings eventually take down the bull, there will be observable shifts in investor behavior as economic concerns increase. Many pension funds must remain fully invested. When they are concerned about the stock market, they cannot convert to cash, but they can move to defensive consumer staples stocks. Conversely, when pension managers are more confident about the economy and earnings, they tend to favor higher-margin consumer discretionary stocks (XLY) over the conservative consumer staples (XLP) sector. The same concepts trickle down to the individual investor and consumer demand levels in the economy. Below, we examine XLY vs. XLP during a period of poor earnings relative to the present day.
Tommy Hilfiger vs. Toothpaste
We like to refer the XLY/XLP ratio as Tommy Hilfiger vs. Toothpaste. When consumers feel secure about their economic stake in life, they are more open to buying designer clothes or taking a cruise. On the other end of the spectrum, consumers who are worried about losing their job will still demand basic necessities, such as toothpaste. Earnings were not good in early 2009. First quarter (Q1) 2009 earnings were announced in early Q2. Money managers and investors started to see the writing on the wall and they began to favor toothpaste stocks over Tommy Hilfiger stocks (see red arrow in chart below). The bottom of the chart shows a period of consolidation in the S&P 500 (orange arrow).
Some Fear Surfaced This Week
If we examine the same ratio as of October 11, 2013, we see a relatively healthy trend in favor of investors demanding consumer discretionary stocks over consumer staples. However, toothpaste stocks did beat Tommy Hilfiger stocks by 2.20% last week, which shows increasing fear about earnings, the economy, and our less-than efficient political process. If the chart below morphs into a look similar to Q2 2009 (see orange box above), it would indicate a shift toward a more defensive stance.
Seven Reasons Apply To Earnings
After Thursday’s monster rally in stocks, we laid out seven reasons the bullish pop was not particularly surprising. The same logic used in the seven reasons piece applies to earnings season; the market’s pricing mechanism is not currently hinting at a slew of bull-derailing earnings reports. One of the seven reasons cited Thursday was the supply and demand balance in bonds. If interest rates begin to fall due to increased demand for safe haven bonds, it would align with increasing economic fears. The recent trend in rates (see below) has been higher, which aligns with the bullish case for stocks and earnings.
Expand Your Horizons
Mean reversion tends to be an “if not when” phenomenon. Foreign stocks have lagged their U.S. brethren for an above average stretch of time. From an earnings perspective, an inside the border portfolio may be overlooking some mean reversion opportunities. From CNBC:
Investors may want to consider companies doing business outside of the U.S., which has seen outsized gains while much of the rest of the world has lagged. “In fact, the earnings revision ratio for multinationals is now at its highest level in 16 months, while pure domestics have seen revisions decelerate,” Subramanian said. “We expect more multinationals can beat expectations this quarter, particularly given trends we have observed out of Europe.”
Intermediate-Term: 2007 vs. 2013
This week’s video makes the assumption that if earnings are to be the final nail in the bull market’s coffin, we would expect to see similarities between the 2007-2008 stock market top and 2013. The video compares the two periods side-by-side.
After you click play, use the button in the lower-right corner of the video player to view in full-screen mode. Hit Esc to exit full-screen mode.
Bears Have Reason To Hope
Stock market bulls would prefer to avoid hearing “worst since” as earnings reports continue to roll out. Corporations have given the bears some reason to hope. From USA Today:
Earnings expectations aren’t exactly sky-high. Almost 100 companies (96) in the Standard & Poor’s 500 have warned that their profits will come in below analyst expectations, according to Thomson Reuters. There have been 5.1 profit warnings for every positive profit pre-announcement. That’s nearly double the long-term average of 2.5 warnings for each upbeat guidance.
Can’t Promise You The World
Officers of publicly traded companies are experts at setting the earnings expectations bar low. From CNBC:
Heading into the third quarter, companies have guided negatively by a 3-to-1 ratio, ahead of the historical average. Though earnings season is still young, just 51 percent of the 21 companies that have reported are ahead of estimates. Downbeat forecasts, then, could have a ripple effect as investors try to determine whether the 18 percent stock market rally so far this year is sustainable. CEOs have a “tendency to underpromise and overdeliver,” said Sheraz Mian, research director at Zack’s Investment Research.
Stop Me If You’ve Heard This One Before
When it comes to earnings expectations and positive surprises, Wall Street veterans have heard this story before; from Yahoo Finance:
Veteran market watchers will say they’ve seen this saga over and over again, as the bar of expectations almost always gets lowered as the day of reckoning approaches. In fact, it could be argued that since pessimism is high enough, and expectations are low enough, that the market could be rife for a string of nice positive surprises.
Short-Term Political Wild Card
How do we use all this? Investors are fighting battles on two fronts. From an intermediate-term perspective, as long as the market’s supply and demand profile continues to point to an acceptable bullish result on the earnings front, we will navigate knowing the bias is to pusher higher on good news.
The second battlefront is based on the debt ceiling and has a much shorter time frame. From that perspective, if the market’s tolerance for risk continues to show observable improvement as it did last Thursday and Friday, we will continue to scale back in with our cash. Our market model continues to favor a global stock approach over an all U.S. portfolio. Consequently our incremental buys Friday included the Vanguard All-World Ex-U.S. ETF (VEU), which has no U.S. exposure, and the Vanguard Total World Stock ETF (VT), which has a 52% / 48% split between foreign and domestic stocks.
If the political process becomes dysfunctional again, we are happy to incrementally scale back toward a more conservative stance. The market will bring us to a prudent allocation if we are willing to monitor the battle between economic conviction and economic fear with an unbiased, flexible, and open mind.
