Sunday, October 21, 2012

Looking Past October's Market Jitters?

Atossa Araxia Abrahamian of Reuters reports, GE, McDonald's give Wall Street a black eye on '87 crash date:
Stocks ended the week on Friday with their worst day since late June after Dow components General Electric and McDonald's, both barometers of the overall economy's health, added to a disappointing earnings season.

Technology shares kept up a pattern of recent weakness, hurt by anemic results from Microsoft (MSFT) and another losing day for Google (GOOG). The Nasdaq closed down 2.2 percent.

For the Dow, Friday's slide marked its biggest loss since June 21 - with the sell-off coming on the 25th anniversary of Black Monday, when the Dow plunged 22.6 percent in its worst single-day percentage drop ever.

For the week, though, the Dow still managed to squeak out a gain of 0.1 percent, while the S&P 500 gained 0.3 percent despite Friday's losses.

Wall Street's mood was sour, given that a large number of companies have fallen short of top-line expectations. Of the 116 S&P 500 companies that have reported results so far, 58 percent have missed on revenue expectations, according to Thomson Reuters data.

"Traders are going to look at things that mimic the U.S. economy - and currently, everything that mimics the economy has been performing awfully," said Todd Schoenberger, managing principal at the BlackBay Group in New York.

General Electric Co (GE) shares fell 3.4 percent to $22.03 after quarterly revenue fell short of estimates.

McDonald's Corp (MCD) lost 4.5 percent to hit $88.72. Chipotle Mexican Grill (CMG) fell 15 percent to $243 after quarterly profits missed analysts' expectations.

The technology sector has been a drag on the stock market, which is a concern because it is seen as a leading indicator of market direction. The S&P information technology sector index  has dropped 5.3 percent in the last 10 days, compared with a 1.9 percent decline for the S&P 500 in that time period.

"Tech has been lagging for almost a month now. It is obviously very sensitive to the U.S. economy, and the global economy for that matter," said Ryan Detrick, senior technical strategist at Schaeffer's Investment Research in Cincinnati, Ohio.

Microsoft (MSFT) dropped 2.9 percent to close at $28.64 after it said it fell short of revenue expectations because of poor sales of PCs.

"The fact they are missing consistently is bringing up a 'sell first, ask questions later' mentality," Detrick said.

Tepid results are being met with particular disappointment because expectations were low to begin with this season, with 95 negative pre-announcements for earnings per share and only 24 positive pre-announcements issued by S&P 500 corporations, Thomson Reuters data shows.

Earnings are expected to drop 1.8 percent in the third quarter from a year ago.

The Dow Jones industrial average lost 205.43 points, or 1.52 percent, to close at 13,343.51. The Standard & Poor's 500 Index fell 24.15 points, or 1.66 percent, to 1,433.19. The Nasdaq Composite Index slid 67.24 points, or 2.19 percent, to close at 3,005.62.

For the week, the Nasdaq lost 1.3 percent.

The sharp decline took the S&P 500 from within striking distance of its highest close of the year - at 1,465.77 set on September 14 - to testing its 50-day moving average. On Friday, the S&P 500 appeared to be testing its 50-day moving average at around 1,433. If the S&P 500 falls below that level, it could trigger more selling.

"The S&P 500 has broken trend-line support at 1,441, and is slipping a bit below its 50-day moving average of 1,433," said Stifel Nicolaus option market strategist Elliot Spar.

Near-term volatility is expected to rise. The CBOE Volatility Index, Wall Street's gauge of investor anxiety, rose 13.5 percent to close at 17.06, off its session high at 17.60. Options expiration added a bit of volatility to Friday's trading.

Volume was roughly 7.27 billion shares traded on the New York Stock Exchange, the Nasdaq and the NYSE MKT, compared with the year-to-date average daily closing volume of 6.52 billion.

Decliners outnumbered advancers on the NYSE by a ratio of more than 3 to 1. On the Nasdaq, about four stocks fell for every one that rose.
There is no question about it, falling revenue is dinging stocks, and the worst hit sector is technology. Some tech stocks are getting whacked particularly hard. For example, Advanced Micro Devices (AMD), a global chipmaker, plunged 17% on Friday on huge volume, closing near its November 2008 low (click on image):


Marvell Technology Group (MRVL), another semiconductor company,  also got slammed hard on Friday, down 14%. Its share price is also at risk of falling back to November 2008 lows (click on image):


The ferocity of these moves is compounded by smart money underperforming the broader market and high-frequency trading platforms wreaking havoc on markets, exacerbating any selloff.

But there may be another 'velocity' impacting top line growth, something much more ominous for stocks and other risk assets. John Mauldin brought to my attention the latest Hoisington Quarterly Review and Outlook (also available here).

In their latest comment, Van Hoisington and Lacy Hunt skillfully argue that despite more quantitative easing in the US and Europe, governments have not been able to address underlying debt imbalances, leaving them to conclude that another global recession is imminent.

I quote John Mauldin:
Their expectation: global recession. The only issue left to sort out, they say, is How deep will the downturn be?

They make the interesting observation that with each injection of liquidity by the Fed, commodity prices have surged: “During QE1 & QE2 wholesale gasoline prices jumped 30% and 37%, respectively, and the Goldman Sachs Commodity Food Index (GSCI-Food) rose 7% and 22%, respectively. From the time the press reported that the Fed was moving toward QE3, both gasoline and the GSCI Food index jumped by 19%, through the end of the 3rd quarter.”

The QE picture gets even muddier. The unintended consequence of the Fed’s actions, say Lacy and Van, has been to actually slow economic activity: “The CPI rose significantly in QE1 and QE2 (Chart 1). These price increases had a devastating effect on worker's incomes (Chart 2). Wages did not immediately respond to commodity price changes; therefore, there was an approximate 3% decline in real average hourly earnings in both instances. It is true that stock prices also rose along with commodity prices (S&P plus 36% and 24%, respectively, in QE1 and QE2). However, median households hold a small portion of equities, and thus received minimal wealth benefit.”

They proceed to tear apart the wealth effect that the Fed is banking on to restimulate the economy, drawing on several solid studies. They also make the key point that “When the Fed actions lead to higher food and fuel prices, the shock wave reverberates around the world, with many foreign economies being hit adversely. When prices of basic necessities rise, the greatest burden is on those with the lowest incomes since more of their budget is allocated to the basic necessities such as food and fuel.”

The next few years are not going to be pretty. We’re looking right into the teeth of a rolling global deleveraging recession—the End Game, I’ve called it. And the decisions we make in the next couple years about how to handle our debts and budget deficits—here in the U.S., in Europe, in China and Japan, and elsewhere—are going to be absolutely crucial.
Now, Mauldin is much more bearish than I am on the US and global economy, but let me dig deeper into something Van Hoisington and Lacy Hunt wrote in their quarterly outlook on how the Fed can't create demand:
The other element that is required for the Fed to shift the aggregate demand curve outward is the velocity or turnover of money over which they also have no control. During all of the Fed actions since 2008 the velocity of money has plummeted and now stands at a five decade low (click on Chart 5 below).

The consequence of the Fed’s lack of control over the money multiplier and velocity is apparent. The monetary base has surged 3.3 times in size since QE1. Nominal GDP, however, has grown only at an annual rate of 3%. This suggests they have not been able to shift the aggregate demand curve outward. Nor, with these constraints, will they be any more successful in shifting that curve under the present open-ended QE3. Increased aggregate demand and thus rising inflation is not on the horizon.
I agree, inflation isn't on the horizon for the simple reason that far too many people are unemployed or underemployed, and real wages continue to be suppressed. Hoisington and Hunt do not believe the titanic battle over deflation will sink bonds, which is why they're still long bonds, and conclude their letter by stating the following:
As commodity prices rose initially in all the QE programs, long-term Treasury bond yields also increased.  However, those higher yields eventually reversed and generally continued to ratchet downward, reaching near record lows.  The current Fed actions may be politically necessary due to numerous demands for them to act to improve the clearly depressed state of economic conditions.  However, these policies will prove to be unproductive.  Economic fundamentals will not improve until the extreme over-indebtedness of the U.S. economy is addressed, and this is in the realm of fiscal, not monetary policy.  It would be more beneficial for the Fed to sit on the sidelines and try to put pressure on the fiscal authorities to take badly needed actions rather than do additional harm.  Until the excessive debt issues are addressed, the multi-year trend in inflation, and thus the long Treasury bond yields will remain downward.
That last paragraph is where they lost me. The truth is that QE hasn't been perfect but it's been a boon for bonds and risk assets. More importantly, if the Fed didn't engage in these policies, and "sat on the sidelines" waiting for the clowns in Washington to act, the US would be experiencing another great depression.

Moreover, as we see in Greece, Italy, Spain, Portugal, and even the UK, the myopic focus on fiscal austerity is counterproductive to bringing debt under control.

Let me repeat what I've often stated, the biggest threat to growth and prosperity is unemployment, not debt. The US and Europe don't have a 'debt crisis,' they have an unemployment crisis which is exacerbating their debt profile. If they don't address the latter, it will only make the former much worse.

Luckily, there are signs that the US recovery is picking up steam. Thus far, the only people benefiting from QE have been the banksters on Wall Street, but that is slowly changing as employment growth is picking up across most states.

And then there is China. What a difference a quarter makes. After months of jitters over a possible hard landing in China, market watchers are quickly turning optimistic on the outlook for the world's second largest economy following a spate of reassuring data this week.

The main sticking point remains Europe, where leaders still have their heads buried in sand, claiming that their strategy is working. It's not working in any way, shape or form, and with Merkel dampening expectations on Friday that Irish and Spanish banks hobbled by the financial crisis would receive direct aid from a newly established European bailout fund, things are going from bad to worse.

Despite endless euro woes, I remain optimistic and think top funds are using the latest pullback in stocks to scoop up risk assets. Coal and nat gas remain my favorite plays and agree with those who claim oil's big fail is distracting investors from the real opportunity (watch below).