Forget Greece - The Market Isn't Pricing in a U.S. Default

Jul.19.11 | About: SPDR S&P (SPY)

By Dirk van Dijk

Second quarter earnings season "officially" got underway last week when Alcoa (NYSE:AA) reported, followed by a handful of other big firms like J.P. Morgan (NYSE:JPM) and Google (NASDAQ:GOOG). However, last week's trickle will turn into a flood this week.

We already have 36 S&P 500 firms that have reported second quarter results. We are off to a very strong start. Those 36 firms posted total net income growth of 20.9% over a year ago. That's down from the 33.6% growth that those same 36 firms posted in the first quarter. Results were also much better than expected, with a median surprise of 5.18% and a 3.57 surprise ratio for earnings.

Top line results are off to a very strong start, with 11.4% year over year growth for the 36, actually up from the 7.61% growth they posted in the first quarter. If anything, the top line surprises have been even better than the bottom line surprises, with a median surprise of 1.88% and a massive 6.20 surprise ratio. In the early going though, the medians and surprise ratios can see very sharp fluctuations, so it is still a bit early to read too much into the results.

For the vast majority still to report (464), the rate of growth is expected to continue to slow dramatically in the second quarter, with total growth of 3.24%. That is down very sharply from two weeks ago. The blame for the decline is mostly due to the financials, and specifically Bank of America (NYSE:BAC). BAC is taking a big hit for a settlement of some of its mortgage problems.

Growth of 11.2% is expected if the financials are excluded, down from 19.9% in the first quarter. I suspect that the actual growth will be somewhat higher than is now expected. Normally, about three times as many firms will report positive surprises as disappointments, and that in turn makes the initial growth projections very conservative.

Revenue growth for the remaining firms is also expected to slow to 5.28%, down from 8.88% in the first quarter. Excluding the financials, growth is expected to slow to 8.84% from 11.93% in the first quarter. Much of the strong revenue growth is coming from the commodity-oriented energy and materials sectors.

Net margins have been one of the keys to earnings growth, but we are starting to see some cracks in that story. The 36 that have reported have net margins of 11.35%, up from 10.45% a year ago. However, the remainder are expected to post net margins of 8.81%, down from last year's 8.98%. Once again, the reason is the financials. Excluding financials, the reported net margins are 9.27%, up from 8.57% last year. For the firms yet to report, if the financials are excluded, net margins are still expected to expand to 8.90% from last year's 8.66%.

On an annual basis, net margins continue to march northward. In 2008, overall net margins were just 5.88%, rising to 6.40% in 2009. They hit 8.64% in 2010 and are expected to continue climbing to 9.45% in 2011 and 10.14% in 2012. The pattern is a bit different if the financials are excluded, particularly during the recession, as margins fell from 7.78% in 2008 to 7.07% in 2009. However, they have started a robust recovery and rose to 8.27% in 2010. They are expected to rise to 8.81% in 2011 and 9.30% in 2012.

Expectations for the full year are very healthy, with total net income for 2010 rising to $794.5 billion in 2010, up from $544.3 billion in 2009. In 2011, the total net income for the S&P 500 should be $931.3 billion, or increases of 45.4% and 17.1%, respectively. The expectation is for 2012 to have total net income passing the $1 trillion mark to $1.056 trillion.

That will also put the "EPS" for the S&P 500 over the $100 "per share" level for the first time at $110.53. That is up from $57.20 for 2009, $83.20 for 2010 and $97.51 for 2011. In an environment where the 10 year T-note is yielding 2.91%, a P/E of 15.73x based on 2010 and 13.42x based on 2011 earnings looks attractive. The P/E based on 2012 earnings is 11.84x.

Estimate revisions activity is starting to pick up again, and analysts will really get busy over the next few weeks. During the seasonal decline in revisions activity, the ratio of increases to cuts also declined sharply from over 2.0 at the height of the last earnings season to slightly below 1.0 for both this year and next. Now as activity is ticking up, so are the revisions ratios, but only slightly; and are about as neutral as they can get at 0.98 for 2011 and 1.00 for 2012.

The fundamental backing for the market continues to be solid. It is important to keep your eyes on the prize. There's lots of news out there, and much of it is more dramatic than earnings results, but rarely does it have more significance for your portfolio. Earnings are, and are going to remain, the single most important thing for the stock market. Interest rates are important, but a distant second.

There are other positive factors as well. The fact we are in the third year of the presidential cycle (almost always the best of the four, and by a big margin). We have a Democrat in the White House, which has historically meant good things for the stock market, with an average annualized return over the last 50 years more than triple when the GOP holds the Oval Office. While counting points on the S&P 500 is suspect over long periods of time, the fact remains that on balance, every single point of increase in the S&P 500 over the last 50 years has come with a Democrat in the White House. Those factors should combine to make this a good year for the market.

The micro level, earnings and valuations, provides plenty of reason to be bullish. This is particularly true when one looks at the prevailing level of interest rates. Currently, 99 S&P 500 (19.8%) firms have dividend yields higher than the yield on the 10 year t-note, and more than half (260, or 52.0%) yield more than the five year note.

One thing is absolutely certain: The coupon payment on those notes will never go up, while companies have been raising their dividends at a rapid pace of late. Nearly one quarter of the firms in the S&P 500 have raised their dividend at a more than a 10% per year rate over the last five years, and those five years include the worst economic downturn since the 1930s. However, the macro level provides plenty of reason for concern, and only some of those concerns seem to be priced into the markets.

In Europe, the debt cancer continues to metastasize. Just after it looked like the Greek problem had been kicked down the road for another year or so (don't kid yourself into thinking the problem is even close to being solved there; there will eventually be a default or a restructuring in which private sector investors have to take substantial haircuts), all of a sudden Italy moved into the spotlight.

Italy is both too big to fail, and also too big to bail out, as the third largest economy in the eurozone, and the fourth largest in the E.U. Even with the "progress" in Greece, Fitch downgraded the country to CCC from B+. Meanwhile Moody's moved Ireland into below investment grade status at Ba1. It joins Greece and Portugal in having Junk grade debt. The worries on the far side of the pond do seem to be priced into the market.

The markets do not seem to have priced in the possibility that it will be the U.S., not any of the PIIGS, that is the first to actually default. OK, interest payments will have first call on the existing cash flow the government has, so China and the other holders of U.S. debt will probably get paid. Everyone else though, should be very worried if the debt ceiling is not raised.

There is a very real possibility that Social Security checks will not go out in August, and doctors will not be paid for Medicare/Medicaid work. I suspect that the paychecks troops in combat would have second call on the current revenues, but the troops stateside might see their paychecks delayed. There is no official protocol on which of the 80 million checks the government cuts each month will have precedence. In any case, the ratings agencies have all made clear they will still downgrade our debt even if the government doesn't default on its other obligations, and even if it continues to make interest and principal payments on the debt.

The difference between Greece and the U.S. is that Greece is unable to pay its debts. The U.S., if the debt ceiling is not raised, will simply be unwilling to do so. That would be entirely an unforced error. The government of the United States defaulting on its debt is likely to have a much larger impact on the markets and the economy than the impact of Lehman Brothers defaulting on its debts. Greece is a rounding error in the world economy relative to the U.S.

America would be shoved right back into recession, and one deeper than the one that followed the Lehman collapse. If that happens, then corporate profits would also collapse. However, when push comes to shove, I find it hard to believe that even Congress could be so stupid as to let that happen. While not the most likely case, the chance of no increase by the time the ceiling is hit is a very real possibility. The GOP is determined to extract everything it can from Obama to allow the increase in the debt ceiling to happen.

When Obama makes a concession, they simply move the goalposts. The latest movement of the goalposts is the new demand that Congress actually approve a Balanced Budget Amendment to the Constitution. The proposed amendment would require that the Federal government spend no more than 18% of the prior year's GDP, and would make increasing taxes almost impossible, by requiring a two thirds majority in both houses. I would note that the last time that Federal spending was less than 18% of the GDP four quarters earlier was in the third quarter of 1965, and has averaged 20.94% since 1948 (and 22.77% since Reagan took office).

It will also happen at a time when the baby boomers are retiring, and thus will be using Medicare and drawing Social Security benefits. It would also remove all flexibility the government has to deal with future crises, be they military or financial. This is a dangerous and decidedly not serious proposal. If the debt ceiling is not raised, just go ahead and throw out all the earnings forecasts for both this year and next. The economic devastation will take down nearly every firm’s results. Total net income for the S&P 500 would be hard pressed to get above $500 billion in 2012, not be over $1 Trillion as is currently forecast.

The budget cuts that the GOP have already forced are slowing the recovery, and the massive cuts they are demanding will slow the economy further. We only grew at 1.9% in the first quarter, which is not fast enough to bring down unemployment. Given weak numbers this week (trade deficit, industrial production, retail sales were all on the weak/bad side) it looks to me as if the growth rate in the second quarter will be below the first quarter pace, probably around 1.5%.

Over the long term we need to close the budget gap, but we need a balanced approach to it. There is zero economic justification for the view that any tax increase slows the economy, and that cuts to spending do no economic harm, or even as some talking heads on CNBC claim, actually help the economy. In theory, both tax increases and spending cuts will tend to slow the economy, but by how much varies a great deal depending on the nature of the tax increases and the nature of the spending cuts. Cutting tax subsidies for, say, ethanol is likely to be far less damaging than say cutting spending on infrastructure.

The most recent plan being discussed is a package of 87% spending cuts and 13% revenue increases, almost all of the revenue increases are from cutting spending that is embedded in the tax code, and which mostly benefits the wealthy. I think that is way out of balance already, but the insistence on 100% spending cuts is simply extreme and will do significant damage to the economy, both short term and long term.

There is a good argument that what Obama should do is simply ignore the debt ceiling and issue debt anyways. There are substantial grounds that the debt ceiling is unconstitutional in Section Four to the 14th Amendment, but an equally strong argument based on Article One, Section Eight that doing so would have the executive branch stepping on the legislative branch's turf. It could well provoke a constitutional crisis. However, given the certain economic armageddon in the form of a default, the third option looks like a good way to go. Raising the option would also restore his leverage in the negotiations.

In the end, I find it almost impossible to imagine the debt ceiling not being either raised or ignored. The most likely scenario, and the one that the markets are clearly betting on, is that there will be a last minute settlement, most likely with Obama folding like a lawn chair. The chance of this game of chicken having a tragic ending is no longer trivial. That tragic ending would result in a huge market crash. Taking out some insurance would make a lot of sense in here.

My preferred way of doing so would be to buy some out of the money September puts. On the SPY (the S&P 500 ETF) the September 120 puts (in the money if the S&P 500 falls below 1200) are only trading for $1.19. Obviously I hope that they would expire worthless, just as I hope that my life insurance policy does not pay off anytime soon. Still it is insurance that would be well worth having.

On balance I remain bullish, and I think we will end the year with the S&P 500 north of 1400, but that does not mean we will have a smooth ride between here and there. Strong earnings should trump a dicey international situation, and the drama in DC (provided it turns out to be just drama, and the game of chicken does not end in tragedy).

Valuations on stocks look very compelling, with the S&P trading from just 13.42x 2011, and 11.84x 2012 earnings. That is extremely competitive with the 2.91% yield on the 10 year Treasury note. However, be prepared to move to the exits (or have some put protection in place) if it looks like the debt ceiling will not be raised. I suspect we are in for a bumpy ride over the next month or so.