The title of Madonna’s hit “Justify My Love” would be a fitting title for earnings season up to now. Thus far the key theme has been:
1. Sell on good news (as with Intel (NASDAQ:INTC)) and sell even more on mixed/bad news (Alcoa (NYSE:AA), JP-Morgan Chase (NYSE:JPM), Citigroup (NYSE:C)). Preliminary market behavior suggests investors remain very concerned about high share prices and valuations, pumped up over 60% since March, relative to likely growth prospects.
2. The critical financial sector, which has led markets both into the current crisis and into the March rally, continues to struggle and is far from healthy. For example
- JP Morgan-Chase (JPM): Down after its announcement of strong bottom-line outperformance, a big revenue miss and disturbing trends in mortgage and card loans. Revenue was off primarily due to a big sequential decline in investment banking revenue. Losses were seen in both mortgage and credit card lending. The firm expects losses at Chase card unit to only increase next quarter, while losses at WaMu unit could climb dramatically. CEO Dimon said that “while we are seeing some stability in delinquencies, consumer credit costs remain high, weak employment and home prices persist. Accordingly, we remain cautious.”
- Citigroup (C): also reflected ongoing fundamental weakness, warning that it could face over $1 billion in credit card losses alone in the first half of 2010, suggesting a grimmer picture for real estate loans.
The reaction reflects the requirement of participants for higher quality earnings and explicit signs that the economic recovery is for real after watching stocks surge since March.
There are plenty of potential time bombs ticking under the foundations of the rally that can and should give investors cause for concern about bidding stocks higher without at least some real retest of support. These include:
- The largest wave of adjustable mortgage rate resets in recent years hitting in 2010-2011, as shown in the table below, from Graham Summers U.S. Housing: The Big Picture.
- As he points out in the article, the last time this magnitude of resets hit it caused a wave of defaults that ultimately crashed the financial sector, and led us into the current economic crisis. Optimism about the recovery of financials sparked the ongoing rally began in March. It’s difficult to imagine any real recovery without the financials returning to health, which will require stable loan portfolios. For borrowers to repay, we need to see, of course, improvements in jobs and consumer spending. However…
- Jobs and consumer spending appear to be bottoming, but have yet to show sustained positive growth needed to ensure borrowers have the income to repay bank loans are once again reliably repaid. Should rates rise, those borrowers will need not merely a stable job market but a growing one that can provide growing incomes to pay higher mortgage rates.
- Risk of Rising Long term Rates: The US has already warned banks to prepare for higher long term rates and conduct stress tests for up to a 400 basis points rate increase. Why? Continued borrowing on an unprecedented scale in the US, UK and much of Europe to keep up the liquidity believed needed for recovery. In recent bond auctions there was an unusually highe percentage of awards to direct domestic bidders, suggesting the Fed was again doing too much of the buying in order to keep prices up and rates down. There is a distinct chance that debt markets may be hitting saturation point at current rate levels, forcing the US Treasury Bond prices down as buyers demand higher rates to compensate for higher risk. Higher long term bond rates mean higher mortgage rates for the wave of resets coming, which in turn raises the chances of defaults and rising default rates. That means more troubles for the banks. In recent years, that has spelled trouble for the economy and stocks.
In short, both general economic data and earnings need to keep improving to justify already high valuations going higher still.
Regarding the critical banking sector, most big names will have reported by the end of this week, including American Express (NYSE:AMX), BofA (NYSE:BAC), Goldman Sachs (NYSE:GS), Morgan Stanley (NYSE:MS) and Wells Fargo (NYSE:WFC). We’ll have a better idea about the sector soon.
How far could stocks pull back? Here’s one idea:
Look at the daily chart of the S&P 500 with Bollinger Bands (settings 2, 20) as shown in the chart below (click to enlarge).
S&P 500 Daily AVAFX Chart: Note how often the index hits its upper Bollinger Band, then pulls back to around the 50 day moving average.
Obviously there are many other factors to consider, but this makes a good quick and dirty tool.
DISCLOSURE: Author has no positions in stocks mentioned