When Will Bad News Cease to be Good News for Stocks?
It is quite amazing to watch this. Even as one economic datum after another indicates that a major slowdown is underway that could well turn into a recession (keep in mind that this is not a certainty - at similar junctures in recent years, aggregate economic data recovered just in the nick of time), the U.S. stock market continues to take everything in stride.
The most recent example was the enormous "miss" of the payrolls report on Friday. The cash market was closed on Friday, but U.S. stock futures still traded briefly after the release, and declined sharply. Whatever concerns futures traders had were evidently forgotten by Monday. After all, weak jobs data mean more free money from the central bank for longer, as the much talked about rate hike will likely be put off further.
It appears, though, that we didn't really get the memo. According to press reports, the market's sanguine reception of the payrolls data miss isn't driven by expectations about central bank policy. Instead, the main driver is "hope". Hope is generally not thought to be an investment strategy, but there it is. What is even more curious is what the hope is all about. A headline at Reuters reads: "Stock markets hope earnings offset weak economic data". Say what?
"Market focus will shift from macro to micro next week, and investors betting on gains in stocks will hope coming earnings reports will be somewhat stronger than recent disappointing economic figures.
Earnings expectations have been falling sharply in the past weeks, with the most recent estimate showing a 2.8 percent decline in earnings growth, squeezed by dwindling expectations for the energy sector. The concern about economic growth will increase following Friday's weaker-than-expected data on jobs growth. Energy companies' earnings are now expected to fall nearly 64 percent year-on-year. Investors saw the sector drop 3.6 percent in the first quarter, bringing the nine-month decline to 22 percent.
Market bulls say softening economic data, including U.S. private sector jobs, factory activity and consumer spending, have weighed on stocks lately. While weak figures keep the Federal Reserve from raising rates - a positive for markets - the negative factors are a concern, said Daniel Morris, global investment strategist at TIAA-CREF in New York.
"We view this payroll number as more negative than positive for U.S. equities," he said. The effect of the strong U.S. dollar on offshore operations and creeping inflation, in the form of higher labor costs, have also taken a toll, one that some strategists think is too pronounced. In Friday's abbreviated trading session, equity futures fell about 1 percent.
"My guess is we've overdone it in terms of concern," said Art Hogan, chief market strategist at Wunderlich Securities in New York. "We always price in the bad news first."
He said that both energy companies pummeled by concern about the sharp drop in oil prices and multinationals suffering from the impact of a stronger dollar might actually be set for positive surprises. "In terms of knee-jerk reaction, surprises are going to come from where we slashed estimates the most."
Despite the rising concern about the earnings season and the weaker data, stocks showed resilience to start the year. This past week the S&P 500 closed its ninth consecutive quarterly gain, even if it was a meager 0.4 percent rise.
"Estimates are down and the market has already absorbed that," said Quincy Krosby, market strategist at Prudential Financial in Newark, New Jersey.
"All you need is some positive surprises for shorts to have to cover," she said, speaking of investors who borrow a stock to sell it, betting on a price decline. "Positive guidance can change the tone of the market quite rapidly."
Chip maker Micron set a negative early tone on Wednesday, forecasting lower revenue for the current quarter on waning customer demand.
More than 80 percent of the earnings pre-announcements this season were negative, according to Thomson Reuters data, setting the bar lower than is usually the case toward the start of earnings season.
In a typical quarter, about 63 percent of companies beat estimates and just above 20 percent miss. But the negativity has set the bar so low, it may have set the stage for a bounceback.
So the market has "priced in" all the recent negatives by briefly visiting levels some 2 or 3 percent or so below its all-time highs. With that out of the way, we can focus on the fact that although earnings are likely to be atrocious, they will still "beat estimates", as Wall Street analysts have wisely set the bar so low after a string of negative preannouncements that it should be a piece of cake for companies to step over it.
We always thought that there can be no such thing as a perpetuum mobile, but once again, we seem not to have gotten the memo. Hope is now not only a strategy in the most, respectively second-most, overvalued market in history - it is a strategy that actually promises to work. Whether the market is deemed to be at the most, second- or third-most overvalued level ever depends on which measures one looks at: based on the median stock P/E ratio and the price/sales ratio, the market has never been more expensive. Based on the cap-weighted P/E, Tobin's Q and CAPE, it is valued somewhere between the 1929, 2000 and 2007 peaks - a state also known as "cheap" nowadays.
According to the people interviewed by Reuters above, it is no longer possible for stocks to decline, since all news is good news; and if any bad news that is actually held to be bad should surface, it can be successfully "priced in" by tiny temporary declines. For the time being, this is actually true. After all, it isn't the news as such that is important for the market - what is important is how the market reacts to it. However, we harbor some doubts as to the perpetuum mobile quality of this state of affairs. At some point, perceptions will change, and then we will likely see the exact opposite - i.e., all news will then be viewed as bad news.
A few large market participants are clearly getting worried about this possibility. Below is a chart of the so-called "CFSB Fear Barometer". What this index shows is essentially the price difference between out-of-the-money calls and puts on the S&P 500 index that are expiring in three months. In short, it is a variation of the "Ansbacher Index" of yore. This price difference is shown by calculating what putting on a cost-free collar would entail: If one sells a 3-month, 10%, out-of-the money call on the S&P 500, how far out of the money would a 3-month put one can acquire with the proceeds have to be? Thus, if the fear barometer is at 20, it means that a 10% out-of-the-money call costs exactly the same as a 20% out-of-the-money put. In other words, a level of 20 would indicate that big investors are prepared to pay up for crash protection. Contrary to what one would normally expect, this is not a contrary indicator in this case, as there is very little retail participation in SPX options. Rather, it is a warning sign.
The CSFB fear barometer over the long term. The recent series of spikes far exceeds the ones seen prior to the 2008 crash. It is a bit odd that the thresholds are referred to as "excessive optimism and pessimism" on this chart. In reality, a high value in the index actually means that the pessimism of institutional investors is rising, or at least their fear of a major market decline is rising.
What Might Upset the Apple Cart?
We can think of a number of things that could interrupt the party, at least for a while. One of those is the unresolved Greek dilemma. Generally, markets seem unconcerned about what happens with Greece and its debtberg, and the possibility that the country might exit the euro. Maybe this is because market participants are convinced a last-minute solution will be found, and that the extend-and-pretend scheme will continue as before. The odds for this have always appeared good, but a number of recent developments are beginning to cast doubt on this notion.
Assuming that Greece indeed defaults and exits the euro, will this necessarily be bad for risk assets? We actually don't know, but we do believe that market participants would be surprised by such a development and haven't given much thought to all the possible ramifications. Apart from the financial losses that would finally have to be recognized and written off by Greece's lenders (which would noticeably increase the public debt of the remaining euro area members), there is also a geopolitical angle to this, on account of Greece's geographical position and its closeness to Russia on spiritual grounds (in both countries, the Orthodox Church is the predominant religion). Alexis Tsipras is actually traveling to Moscow, presumably to solicit president Putin's help.
Recent developments include the IMF withdrawing its experts and negotiators from Athens, due to the fact that "there have been only four days of negotiations since the change of government in Athens," and as it appears that "no progress is foreseeable" at the moment. At the same time, it is still not certain if the Greek government will actually be able to pay the €462 million it is supposed to pay to the IMF on April 9. Announcements to this effect keep changing. One announcement was that the payment would have to be delayed - which would be the first such default by a borrower in the IMF's entire history; then, some other government spokesman let it be known that the payment would actually take place as scheduled. No one knows yet what will really happen. It seems, however, almost certain by now that Greece will be unable to make one or more of the subsequent payments scheduled between now and mid-May:
Greek debt payment schedule until mid-May: the first €462 m. are due to the IMF.
Greece is a "gray swan" in a sense. It is a well-known problem, but at the same time, it seems quite unlikely to us that a Greek default is actually "priced in". The same is probably applicable to the recent string of weak U.S. economic data; it seems to be widely assumed that this is only a transitory phase and that economic growth will soon resume. This is evidently the consensus, and as such, it is vulnerable to disappointment. At the same time, the Fed still seems set on a rate hike course; it will be difficult for it to back-track in light of the need to preserve its vaunted "credibility", especially if the stock market remains strong. A strong stock market, after all, is held to indicate that there is no problem. Unfortunately, the market is usually completely wrong at important junctures. Its often demonstrated failure to discount even blindingly obvious problems should certainly give one pause (we discussed this back in 2012 in "What Does the Stock Market Really Know?").
We would be quite surprised if upcoming corporate earnings fail to beat lowered expectations, but that will, of course, not change the fact that earnings growth is actually turning negative this quarter - for the first time since 2009. Similar to other less-than-encouraging developments, this isn't going to matter until it does, but as noted above, once perceptions change, everything will all of a sudden matter.
Below, we show an update of the rather obscure, but in our opinion, quite useful Rydex indicators. Rydex funds are only a very small slice of total market activity, but they still represent a microcosm of sentiment and positioning that is relevant as a stand-in for market-wide sentiment. Think of them as akin to a survey, in which a small number of respondents is usually sufficient to detect nation-wide trends in public opinion. Although the backdrop to the current bubble is different from that of the 1990s in terms of the wider public's enthusiasm for the market (there are no signs yet that people are leaving their day jobs en masse to become day traders), these indicators show that among regular market participants, market sentiment and positioning has never been more lopsided than in recent months.
The reason to show an update is that a measure of uncertainty has recently crept in. The ratio of bull assets to bear assets has begun to fluctuate quite a bit, mainly due to continual and rapid buying and selling of bull and sector assets. Both bear assets and money market fund assets remain stuck near all-time lows, so only very few can be accused of being cautious or - gasp! - even bearish. Of course, this has been the case for quite some time, and it has yet to affect the market negatively. However, from experience we know that the longer such extremes persist, the more harrowing and long-lasting the eventual denouement will be. Putting this into context with the fear barometer discussed above, we would expect that sometime this year, major market upheaval should begin. Unfortunately, we cannot provide an exact date (for this, we refer you to the mighty Zoltar).
Rydex money market fund assets, bear assets and the bull-bear asset ratio. The former are stuck near all-time lows; the latter has begun to display an increase in volatility of late.
As always, we must point out that money supply growth still remains brisk, with money TMS-2 (broad true money supply) growing at a rate of 8.35% year-on-year. This is probably the one thing that continues to strongly support the market and makes it so resilient to other influences. Much of this money supply growth is currently due to an expansion in inflationary lending by commercial banks, especially in terms of commercial and industrial loans. A lot of this lending likely supports - directly or indirectly - various financial engineering activities, primarily stock buybacks.
Broad U.S. money supply TMS-2: recently (as of the end of February), the annual rate of growth stood at a still hefty 8.35%.
Conclusion
The stock market continues to be impervious to what would normally be considered negative developments, ranging from a deterioration in macro-economic data to weakness in corporate earnings. As long as the market ignores seemingly "bad news", it remains a bull market. However, as bull markets go, this one is very long in the tooth and has already, some time ago, attained bubble proportions. It is never knowable with certainty just how big a bubble will become; for instance, between the final quarter of 1999 and the first quarter of 2000, the market demonstrated that utter insanity can sometimes find expression in stock prices, as long as there is a "good story" and plenty of liquidity. Given the unprecedented (in the post-WW2 era) central bank experiments underway since the crisis, it is especially difficult to gauge when and at what levels the bubble will expire. However, the longevity, intensity and persistence of a bubble is per se not proof that it will inevitably continue - it is only an indication of the likely amount of pain the market will eventually dispense.
(Charts by: StockCharts, Der Spiegel, SentimenTrader, St. Louis Federal Reserve Research)
