With Alcoa (AA) kicking off the second quarter's earnings announcement season, investors are eager to gain insights on just how much the EU crisis has impacted corporate profits.
Key economic data was disappointing in Q2, and negative preannouncements are at record highs:
(click to enlarge)
(click to enlarge)
Lack of a Reasonable Discount
With the S&P 500 only 4.7% below its 52 week high, equities haven't meaningfully priced in a weak earnings cycle. Despite earnings forecasts having been ratcheted down significantly and a weaker (relative to Q1) global economy, stocks are down only marginally from their highs. Additionally, stocks are one of the major asset classes that has yet to fully retrace the misguided EU Summit "progress." Meanwhile, the Euro is now valued at its 2-year low, peripheral sovereign bonds are back at their lows (Spain and Italy), and credit markets have also retraced their gains.
Most market literature seems to argue that investors are exceptionally pessimistic, implying little remaining downside. While sentiment was overwhelmingly bearish a few weeks ago, the AAII survey shows that bearishness declined 11% from last week, down to a much more reasonable level at 33%. Meanwhile, fear indicators like the VIX (VXX) reflect severe complacency. Despite a modest spike in Friday's post-jobs report chaos, the index plummeted at the close and is indicative of a market that has refused to maintain a reasonable risk discount.
Data Dump: Upcoming Earnings and Macro Data Releases
Here are the key upcoming earnings announcements for the next few weeks:
Alcoa: expected to show marginal profitability, but has significant exposure to the EU
JP Morgan (JPM)/Wells Fargo (WFC): Reporting on Friday the 13th; JPM's announcement is huge and will finally reveal the extent of the bank's trading loss.
Intel (INTC): Reports on the 17th. Massive revenue exposure to Europe.
Johnson & Johnson (JNJ): Also reports on the 17th. Earnings will provide insights into consumer spending.
Schlumberger (SLB): Reports July 20th. Earnings should show weaker demand of SLB's services by the oil majors, given the huge decline in oil prices and underlying commodity demand.
And the major economic reports:
Fed Minutes: Wednesday, July 11th. Is QE3 now imminent? The Euro/USD doesn't seem to think so.
Chinese GDP: July 12th. Expected to come in at 7.6%. Given the contracting manufacturing PMI number (the HSBC figure), Chinese economic activity is slowing a bit more rapidly than expected.
Jobless Claims: Last Thursday's beat of 374K has analysts expecting a positive trend to now emerge. Only 364K are expected to have filed for the previous week, a relatively sharp divergence from the 4 week rolling average.
US 2Q GDP: July 27th. This is obviously the most anticipated number, and the forecast of 1.7% is too rosy. The misses in the ISM data reports indicated weak activity and a sharp decline in new orders. While the employment segments of both ISM reports were not indicative of a recessionary environment, a mere 2 basis point drop from 1Q GDP seems too optimistic. First quarter GDP got a now well-publicized boost from seasonal adjustments, and the removal of such adjustments in conjunction with a deteriorated global economy should result in a figure closer to 1%.
Conclusions
Equities have failed to accurately price in reduced earnings estimates and a global economy that is trending towards a moderate recession. With stocks less than 5% off their 2012 highs, valuations simply don't match up with the change in the underlying fundamentals.
Coordinated global central bank easing failed to move markets last Thursday, which was indicative of the small medium-term upside for equities. Failure to react aggressively to bullish news is a classic indicator for medium-term tops.
The risk/reward profile has now shifted in favor of those who are shorting stocks. I recommend shorting broader equities via conventional methods (short futures, buying puts on the SPY, unhedged shorts on the SPY, etc.), but high valuation, weak fundamental stocks like Salesforce (CRM) are likely to lead the market lower over the next several weeks.
Additional disclosure: Short S&P 500 Futures, short CRM via Puts
