'BTE' Earnings Masking Signs of Coming Market Correction?

Given the lack of excessive inventories, e.g. indicated in Intel's (INTC) Q3 report, Wall Street’s scenario that I outlined in my Oct 5 weekly article of better-than-expected (BTE) 3Q earnings leading into typical 4Q seasonal strength, with huge year-end Wall Street bonuses, is still quite possible (Wall Street's BTE game is highly manipulated).

But now there are the following early signs that the market may correct, perhaps after 3Q earnings are mainly reported later this month.

Some Early Signs of a Possible Market Correction

1) The market response so far to BTE 3Q earnings has been more muted than in 2Q, a more typical “buy the rumor, sell the news” reaction (see next section);

2) This has been reflected in market breadth negative divergences (see chart at end of article), key resistance on SPX is 1100 and 1121 (50% Fibonacci retracement from Oct 07 high to Mar 09 low);

3) The breakout in oil, gold and CRB, GSCI commodity indexes may increase pressure on the Fed to move forward its exit strategy from unprecedented easing;

4) Despite the latest BTE trade figures from China and S. Korea, the Shanghai and Kospi stock indexes (the latter being a good leading global indicator, see chart at end of article), are not yet confirming SPX new highs, due to ongoing concerns about the removal of easing (e.g. in 4Q, possibly higher bank reserve ratios in China and 25 bp interest rate hike in S. Korea);

5) The increasing strength in Brazil’s Bovespa and other commodity-oriented emerging markets, and the new 52-week low in VIX, are other signs that global risk trades are increasingly over-crowded and overbought;

6) The ongoing decline in the dollar continues to be risky, should it accelerate too far too fast. In the long-term big picture, something that might matter that didn’t receive much mainstream media attention last week (e.g. not on the front page of the NYT and WSJ) was the visit of Russia’s Putin to China, where the two countries signed major agreements, including for energy.

7) Last but not least, low long-term interest rates, which have risen about 20 bp in Oct, seem to be still telling a much different slow growth/low inflation economic story than increasingly frothy risk asset markets, such as equities, commodities, and junk bonds.

Market Response to 3Q Earnings So Far Typical “Buy the Rumor, Sell the News”

So far 3Q earnings are significantly BTE, with very preliminarily even a higher percentage of estimate beats than in 2Q, which was a record (again, this is simply Wall Street's highly manipulated game).

But the bar has clearly been raised much higher, in terms of equity prices and expectations, from 2Q, with “whisper numbers” above consensus even more than usual (e.g. in the case of GS), resulting in more muted equity price gains. Stocks of companies reporting the past week have been reacting in a more typical “buy the rumor, sell the news” manner.

There was a lot more uncertainty before 2Q earnings reports regarding how well the BTE 2Q macro data would translate into corporate earnings. The answer turned out to be surprisingly strong, as corporate margins were much BTE, due to cost cutting.

This time around, SPX started rallying earlier in anticipation of the good earnings news then it did in 2Q, the current leg up started Oct 5 before Alcoa reported Oct 7. The market’s 2Q leg up started July 13, when Meredith Whitney upgraded Goldman Sachs (GS) before the market opened on CNBC. On Oct 13, Whitney downgraded GS to neutral on valuation.

Current Speculative Capital Markets Cannot Distinguish True Economic Earnings

This past week of 3Q earnings was supportive of the basic point made in my two most recent weekly articles, Sept 28 “’Easy Money’ Is Over” and Oct 5 “Will 3Q Earnings Trump Increased Macro Risks?”, i.e.:

In the first “easy money” seeking beta stage, which is now over, all the more risky global assets (e.g. junk bonds, emerging markets, small cap stocks, some financial stocks, etc) have indiscriminately gone up a huge amount [on the simple bet of an early economic recovery]. Wall Street now hopes that in the next seeking alpha stage, the market will supposedly start to better differentiate between the true economic winners and losers, be it entire asset classes or individual securities.

Unfortunately, current speculative financial markets and the mainstream business media can not distinguish the true economic difference between the BTE earnings of an INTC (which may hit record gross margins next quarter) and the trading profits of a GS, a distinction not as lost by America's economic competitors, and hence these markets have not provided rational capital allocation, which was the essence of the credit crisis, contrary to prevailing mythology. INTC is one of the remaining bastions of high-tech manufacturing left in the U.S., and its “Moore’s law” innovations have helped provide the technological underpinning for progress for over four decades.

Bears and Populists Negative Spin on Goldman and Financials

Last week bears negatively spun key financials’ (Bank of America (BAC), Citigroup (C), JP Morgan (JPM)) earnings reports, e.g. noting that trading continued to be much more profitable than extending credit to the real economy, the ostensible rationale for the bailouts and unprecedented easing, especially for the most profitable trader, GS, whose bonus accrual drew populist ire.

That’s understandable, given the circumstances, but so far such views have not had much market impact. As far as Wall Street and Washington are concerned, the “new normal” is pretty much still the "same old game," which is certainly not surprising. E.g., this quote from Oct 7 WSJ:

So while American consumers remain weighed down by debt, "the stock market is telling us that it can do just fine, thank you," says Robert Doll, BlackRock Inc.'s global chief investment officer for equities.

One might make the case that many Americans didn’t seem to dislike rampant speculation as much in principle (e.g. in the real estate and tech bubbles before they collapsed), but rather mainly when they were no long being cut in on it, as is currently the case, which goes against the modern-day speculative version of the ethos of “shared sacrifice.” Wall Street and Main Street are no longer joined, as they somewhat were during the real estate bubble (with, of course, the lion’s share going to the former).

Will Populist Anger Impact the Market?

If that disparity continues, and right now it seems unlikely that Bernanke’s unprecedented efforts to salvage Wall Street’s mortgage securitization market will restart the middle-class refi ATM of 2003, and especially if the economy takes another turn for the worse, then obviously there could be some major political impact on the economy and stock market, perhaps with the vote over the Dems’ upcoming healthcare bill also serving as a potential catalyst.

At the moment I’m not factoring in the risk of this political scenario, not adding it to my 16 market factors, but not ruling it out. For populist anger to coalesce into something more politically powerful that might impact U.S. and global financial markets, it may need to focus on a more coherent agenda than I currently am aware of.

E.g., while many in the middle class now dislike government involvement in liar mortgage loans, Fannie Mae (FNM) and Freddie Mac (FRE), “socialized medicine entitlements,” etc, they seem to take for granted their own mortgage interest tax deduction, real estate capital gains tax exclusion, tax advantaged employer-provided health insurance, and Medicare generational wealth transfer.

Shedlock's “Look at ECRI’s Recession Predicting Track Record”

Since I’ve used ECRI’s Weekly Leading Index (WLI) in a number of articles, I should note that Shedlock did a thorough blog on ECRI’s forecasting claims, picked up by Krugman in his blog, and then answered by ECRI.

I won’t go into the details of the dispute. My trend following of ECRI WLI and equity market indexes, which have stayed in sync since the March lows in both, served its purpose for me in the first stage of the recovery, which so many were denying. Then, as I said in my Sept 28 “”Easy Money’ Is Over” article, "that may no longer be enough,” so I’ve de-emphasized WLI in my past two articles (should it significantly diverge from market indexes, I may comment).

More generally, I never just blindly follow any one indicator throughout a cycle. My initial weekly articles on Seeking Alpha went into considerable factual detail on 16 different market factors, leading indicators such as WLI being one of them. I take them all into account in making market judgments, some more than others at different times. (I’ve omitted going into detail on these factors in recent articles for brevity.)

Market Will Correct When All News Not Viewed Benignly

Up until now, almost all market news has been viewed benignly. A good sign that the market will be in danger of correction will be when that is no longer the case.

E.g. Australia’s recent rate hike was viewed positively by the market, as a sign of economic strength. The weak Sept U.S. employment report was also viewed positively, as a sign that the Fed won’t be removing easing any time soon.

A typical example during this rally of heads the bulls win, tails the bears lose. As I noted at the outset of this article, there are now some incipient signs of that changing.

Click to enlarge:

Comments

[Owen B:]

Thanks for the update, and list of things to watch as warning signs of a possible correction. However, I disagree with the characterization of Shedlok's article as "thorough." ECRI's reply shows that Shedlok's understanding of the WLI is limited.

www.businesscycle.com/.../

www.ritholtz.com/blog/...

Oct 19 04:33 PM

[Paul Bishop:]

As always good data, thoughtfully presented. It is tough to track that many indexes and make any sense out of them, so the analysis is
extremely valuable.
While Wells reported good numbers it's clear they are still dealing with all the losses from Wachovia, as they continue their write downs. Many Banks will be forced to flush a lot of property in the 4th. qtr. to take the losses this year. It is no mystery why they aren't lending, with the portfolios they are carrying, they can't make a 80% LTV loan when they know the Value has more downside. My guess is there are close to 45,000 homes in the 9 county Bay Area that are in some stage of the foreclosure process, nothing is going to move appreciably until this is washed out. The nicer homes and neighborhoods are now beginning to be hit, and with the Holidays on us, more and more product will just sit. It will be hard to have any sustainable rally until the RE mess is adequately dealt with.

Glad to have John's input.

Oct 21 08:15 PM