S&P Earnings Hurt By Weak Energy & Financial Results

| About: SPDR S&P (SPY)

The S&P 500 fell 1% last week and -1.63% for the first half of October, due in part to this dismal political scene. The S&P is up only 1.2% in the past 15 months, as investors are distracted by this political circus. The last Presidential debate was an outlandish mix of Entertainment Tonight and Ultimate Fighting, while the third (thankfully final) debate tomorrow night promises to be even worse. Like most of America, we are simultaneously in shock and being entertained, all at the same time, by this Presidential election cycle.

We're seeing that when Donald Trump seems backed into a corner, he will come out fighting and will not hold back. Like a good boxer, Trump seems to want to lure the media into beating him up; and then, when he seems to be on the ropes, he counter-punches viciously. Trump seems to be running against what he calls a biased news media - as well as the Washington establishment, including many in his own party!

Like much of America, I do not think that the Presidential election can get over soon enough, so we can finally move on, but there may be some glitches after the election. The Electoral College naturally favors Hillary Clinton, but she needs a big winning margin. Trump will benefit from a strong turnout from his passionate anti-establishment base. My fear is that Hillary Clinton will win the Electoral College by just a few votes, causing recounts in one or two states. I would not be surprised if Trump tries to contest those states and declare that the process is "rigged," causing the political circus to continue after Election Day.

This political circus won't hurt the stock market much, in my view, if Hillary emerges as a clear winner. But if a recount is required, then any prolonged vote count will tend to promote even more uncertainty.

Like the political world, the stock market sometimes lives in a fantasy world. The analyst community is almost always too optimistic, so I expect wave after wave of analyst earnings estimate cuts in the New Year. In the meantime, third-quarter earnings for the S&P 500 are expected to decline by -0.7%, which would be the sixth quarter in a row of negative earnings; but when energy and financials are excluded, the earnings environment is actually positive and gradually improving, thanks in large part to more favorable year-over-year comparisons from the negative growth rates in late 2015.

Energy remains the primary drag on the S&P 500, since third-quarter energy company sales are expected to decline by 11.3% and third-quarter energy earnings are forecasted to plunge by an astonishing -68.4%.

Also, three of America's biggest banks reported third-quarter earnings declines last Friday, falling 15%, 17%, and 4%, respectively. Today's relatively flat yield curve is helping to destroy these banks' profits. As a result, financial and energy stocks remain a significant drag on third-quarter S&P 500 earnings.

Ironically, many energy stocks continue to benefit from surprisingly high crude oil prices as the futures market speculates that Russia and Saudi Arabia may curtail their respective production. This will not happen, in my view, nor will OPEC be able to enforce a production cap at the end of November. Just like any other political banter, the gossip in the oil patch has been keeping crude oil prices artificially high.

Both the American Petroleum Institute and the Energy Information Administration reported last week that crude oil inventories resumed rising in the most recent week, but I remain frustrated that many money-losing energy stocks continue to perform relatively well. That is partially due to the high-dividend yields for many flagship energy companies, as well as the indexing/ETF boom - since ETFs must include all relevant companies, including those with negative sales or earnings. As a result, some weak companies are still trading strong. Some of them should eventually sink since fundamentals can't be ignored forever.

My management company just released a new white paper entitled, "Sharks, High Frequency, and ETFs." It's all about the increasingly manic nature of the stock market, fueled by algorithmic arbitrage traders jerking ETFs around, since ETFs are increasingly trading at a discount to their underlying Net Asset Value (NAV). Nonetheless, ETFs are here to stay, since investors like low fees, even if they sometimes have to pay a premium to buy an ETF, or sell at a discount, while having no idea they are being fleeced.

Interestingly, the "smart Beta" revolution is actually increasing the ETF premiums or discounts to NAVs, since those ETFs tend to be more thinly traded. They are also rebalanced aggressively every 90 days, which makes it very lucrative for many ETF sponsors and their specialist affiliates to trade ETFs. Since I started one of the first smart Beta ETFs several years ago, I know all too well about ETF specialists and the resulting price anomalies, so I hope that you will find my management company's latest white paper a fascinating look at the inner workings of how ETFs trade and attract algorithmic arbitrage traders.

I will openly admit that I despise indexing and want to invest solely in companies with positive sales, earnings, and increasingly-growing dividends. The reason is simple. These companies tend to be more predictable and less volatile. I would rather be a "fast turtle" and win the race with consistent, predictable companies. I will let the "rabbits" (e.g., algorithmic traders) run around and burn themselves out as they arbitrage volatile sectors and ETFs. These Wall Street rabbits are increasingly manic and are responsible for the herky-jerky stock market action that we have seen this year. My quantitative grading system in both Dividend Grader and Portfolio Grader naturally avoids volatility, so I continue to avoid most financial and energy-related companies where the rabbits run, creating a lot of unnecessary volatility.

The FOMC Minutes Reveal a Sharply Divided Fed

On Wednesday, the Fed released the minutes from its latest (September 20-21) Federal Open Market Committee (FOMC) meeting, which revealed the infighting behind its 7-to-3 vote to postpone raising key interest rates. However, the FOMC minutes also revealed that the Fed was laying the groundwork to raise rates "relatively soon," implying a sharply-divided Fed. As the minutes put it,

Some participants believed that it would be appropriate to raise the target range for the federal funds rate relatively soon, if the labor market continued to improve and economic activity strengthened, while some others preferred to wait for more convincing evidence that inflation was moving toward the Committee's 2% objective.

Regardless of the infighting within the FOMC, most economists expect that the Fed will most likely hike key interest rates at its December FOMC meeting, during the holidays, just like they did last year.

I should add that there are potential glitches that could derail the Fed's plan to raise key interest rates. There are growing concerns about global economic growth after China announced on Thursday that its exports declined 10% in September, which was much worse than economists' consensus estimate of a 3.2% decline. The persistent weakness in global demand has caused China's exports to decline for six straight months. Domestically, China is also apparently struggling, since its imports declined 1.9%.

A stronger U.S. dollar is also expected to put more downward pressure on U.S. exports and commodity prices. The British pound, euro, and Chinese yuan have all fallen dramatically to the U.S. dollar, so the capital flight to the U.S. will likely continue and put downward pressure on market interest rates.

On Friday, the Commerce Department announced that retail sales rose 0.6% in September, slightly below economists' consensus estimate of 0.7%. Despite this narrow miss, the fact that retail sales rose in September was welcome relief after retail sales declined a revised -0.2% in August and rose only 0.1% in July. The fact that retail sales increased 0.2% in the third quarter will contribute a bit to GDP growth.

The big contributors to September's retail sales increase were vehicle sales (+1.1%) and gas station sales (+2.4%). Excluding auto and gasoline sales, retail sales rose 0.3% in September. I particularly like the fact that restaurant sales rose 0.8%, the biggest monthly increase since April. When folks are dining out at restaurants, that is a good sign that consumer confidence is healthy. Overall, the September retail sales report confirmed that the U.S. remains in a "Goldilocks" economy that is neither too hot or too cold. As a result, the Fed will remain accommodative and not increase key interest rates too fast, in my opinion.

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