Last week, we presented some indicators which suggested the S&P 500's 4.3% slide in the first seven trading days of April may prove to be more than just a little spring cleaning (please see What if risk assets are heading lower, not higher?, April 16, 2012). That said, the war between the macro (e.g., U.S. durable goods manufacturers' negative surprise) and the micro [e.g., Apple's (AAPL) positive earnings surprise] has buffeted equities between a breakdown or a breakout from their recent trading range.
In terms of the downside risks, are there any other signs of more sinister things to come? Perhaps a comparison with last spring's market backdrop and share price dynamics might provide some insight. From April 1 to June 30, 2011, the S&P 500 experienced two shallow corrections of 2.3% and 7.2%, and managed to hold its ground until the summer (when it dropped 17.3% from July 7 to August 8, as the debt ceiling debate reached maximum intensity and the outlook for the U.S.'s long-term sovereign credit rating darkened).
In our view, there are some important differences between spring 2011 and spring 2012 which underscore the downside risks ahead for stocks. They include:
1.) Liquidity - We've heard much from the bullish camp about synchronized global central bank liquidity support. Don't get us wrong; we rode the liquidity wave into 2012 ourselves (please see A Crisis of Confidence, September 29, 2011). However, it appears to us that worldwide monetary policy is becoming lopsided, especially on the part of the Fed. Last spring, the Fed's balance sheet expanded by $243 billion (9.2%) from March 30 to June 29 (and increased another $13 billion or 0.5% to July 13). This spring, its balance sheet has actually contracted by $3 billion from March 28 to April 18 (-0.1%), and has shrunk $62 billion (-2.1%) from its peak on February 5 (figure 1). Furthermore, with Operation Twist set to conclude in June, the outlook for liquidity support seems cloudy at best. The bottom line is, this time around, there's less liquidity support for stocks at the margin.
Figure 1: This spring, the Fed's balance sheet has actually contracted by $3 billion, meaning there's less liquidity support for stocks at the margin
2.) Sentiment - There are many different surveys that attempt to capture investor sentiment of some kind. The American Association of Individual Investors' (AAII) Investor Sentiment Survey is one we monitor on a weekly basis. It measures the percentage of members who are bullish, bearish, and neutral on the stock market for the next six months. At the extremes, it has generally been a decent contrarian indicator for equities, meaning the bears tend to maul the survey around market bottoms and the bulls typically stampede near tops. Last spring, the bull-bear spread (i.e., the difference between the bullish and bearish percentage) fell to a negative extreme of -23 percentage points on June 9 and bounced along that low a couple more times before the S&P 500 finally bottomed on October 3. This spring, the bull-bear spread has fallen to a low of just -13 percentage points on April 12, and actually rose to -10 percentage points on April 26 (figure 2). Historically, the stock market tends to put in a convincing bottom when the bears are looting and the bulls have completely pulled in their horns. Today, that doesn't appear to be the case.
Figure 2: Historically, the stock market tends to put in a convincing bottom when the bears are looting and the bulls have completely pulled in their horns
3.) Earnings - If you've ever wondered whether trends in earnings growth matter for equity returns, take a look at figure 3. It shows the year-over-year percent change on S&P 500 trailing 12-month operating earnings per share (EPS) alongside the year-over-year percent change on the S&P 500 index since 1990. Clearly, there's a relationship: On a trend basis, equity returns usually benefit from accelerating earnings growth, and generally suffer from slowing earnings growth. Last spring, S&P 500 quarterly operating EPS grew 16.4% y/y (1Q11). This spring, EPS are growing only 6.4% y/y (1Q12) according to Capital IQ's bottom-up consensus estimate (figure 4). In other words, there's less earnings support at the margin.
But what about the significant positive earnings surprises we've seen so far this reporting season? On April 19, Howard Silverblatt (senior index analyst at Standard & Poor's) told us: "The current beat rate of 80% is unusually high (the last five years have averaged 67%), just as last quarter's 49% beat rate was low at this point in the cycle. The major difference is that 1Q12 earnings estimates declined enough over the last several months for the actuals to be able to beat the estimates. Q1 estimates stopped declining on March 18, and have increased as 24% of issues (32% of market value) have reported." We've always questioned the efficacy of earnings surprise models, specifically the link between the surprise to consensus sell-side earnings estimates and share price performance. To us, it seems the surprise says more about the quality of the estimates than it does about the underlying trend in earnings.
Figure 3: On a trend basis, equity returns usually benefit from accelerating earnings growth, and generally suffer from slowing earnings growth
Figure 4: This spring, EPS are growing only 6.4% y/y (1Q12), meaning there's less earnings support for stocks at the margin
4.) Europe - Last spring, we had a "minor" Greek tragedy while Euro Area real GDP grew 0.8% q/q (1Q11). This spring, we have a major Spanish and Italian Inquisition while Euro Area real GDP fell -0.3% q/q (4Q11) and the momentum isn't looking good for 1Q12 (figure 5). This week, we learned that the Markit Flash Eurozone PMI Composite Output Index (a weighted average of the Manufacturing PMI Output Index and the Services PMI Activity Index) dropped from 49.1 in March to 47.4 in April. Keep an eye on Spanish and Italian spreads. If Spain and Italy were "known" quantities, we doubt spreads would be so wide.
Needless to say, these trends bode ill for S&P 500 companies' global sales. Based on the 50% of S&P 500 companies with full reporting information, foreign or non-U.S. sales represented 46% of global sales in 2010. Importantly, Europe represented 29% of foreign sales, which means the region accounted for 13% of global sales, the second-largest category after that nebulous "Foreign Countries" bucket (please see S&P Indices, S&P 500: 2010 Global Sales, July 19, 2011). Of those U.S. firms that do report foreign sales, few are required to specify where they're derived. When a U.S. company reports foreign sales but doesn't provide a breakdown, it gets thrown into the "Foreign Countries" category. The bottom line is there could be more European exposure in that general bucket than U.S. firms specify.
Figure 5: This spring, we have a major Spanish and Italian Inquisition while Euro Area real GDP fell -0.3% q/q (4Q11) and the momentum isn't looking good for 1Q12
5.) China - Last spring, China real GDP grew 2.2% q/q (1Q11) and accelerated to 2.4% q/q (3Q11). This spring, China real GDP decelerated to 1.8% q/q (1Q12), the slowest rate in 3 years. This week, we learned that the HSBC Flash China Manufacturing PMI ticked up from 48.3 in March to 49.1 in April, but is still contracting. In other words, the engine of global growth is running low on gas.
Figure 6: This spring, the engine of global growth (i.e., China) is running low on gas
6.) U.S. Treasury yields - Last spring, 10-year U.S. Treasury yields were in the 3.0-3.5% range. This spring, they're around 100-150bps lower at about 2%. In figure 7, we plot 10-year U.S. Treasury yields versus the S&P 500 since 1998. As you can see, there was a positive correlation between stock prices and bond yields until late-2011, when the two series began to diverge. One explanation for this disconnect is the bond market has much less confidence than the stock market when it comes to the growth outlook. Another explanation is Operation Twist, which began in October 2011 when the Fed started selling shorter-dated Treasuries and buying longer-dated ones. From our lens, this is just another way of saying the Fed is less optimistic than stocks about economic prospects, and is trying to support a stronger economic recovery by keeping the federal funds rate at exceptionally low levels at least through late-2014. Indeed, the FOMC stated this week that: "Strains in global financial markets continue to pose significant downside risks to the economic outlook."
Figure 7: Bonds & the Fed have less confidence than stocks in the growth outlook
Are we spending too much time worrying about the downside risks? Is it possible the bond market and the Fed are wrong, and the stock market is right? We can't be certain, but perhaps we'll get some clarity when Operation Twist ends in June.
Figure 8: Who's right - bonds & the Fed, or stocks?