Stocks Headed Lower As Corporate Profits Peak And Households Rein In Spending

 |  Includes: EWZ, FXE, FXI, SPY
by: David Frazier

Economic conditions around the globe continued to deteriorate over the past few weeks, yet stock prices in general moved higher as market participants were led to believe that central banks would soon implement additional measures to try and stimulate economic growth. Although many investors were encouraged by the recent rebound in stocks, my research indicates that stock prices have peaked for this phase of the economic cycle and that stocks will trend lower during the months ahead.

Meanwhile, the net reading on my Tactical Asset & Sector Allocation Model, and associated Buy-Sell Index, has remained in substantial sell territory after registering a sell signal on June 1. Therefore, I urge investors to continue to allocate a large portion of their financial market assets to money market funds and to allocate a portion of their speculative money to inverse-equity ETFs. (Note that on April 1, I advised subscribers to my investment newsletter to get completely out of stocks.)

In the sections below, I discuss some of the major factors and developments that support those recommendations.

Major Economic Developments in the United States

Economic conditions around the world have continued to deteriorate since April. Meanwhile, the recent readings on numerous leading economic indicators suggest that the pace of economic growth in most regions of the world will continue to slow during the second half of this year.

As a result of the slowdown in worldwide economic growth, the profits of U.S. companies declined during the first quarter of this year after rising to an all-time high during the fourth quarter of 2011. That's a very significant development because the level and direction of stock prices is ultimately determined by the level and direction of corporate profits (see the chart below).

Click to enlarge images.

U.S. Corporate ProfitsClick to enlarge

Looking forward, analysts at S&P Capital IQ, which is the research division of Standard & Poor's, estimate that corporate profits for companies that compose the S&P 500 continued to decline on a year-over-year basis during the second quarter of this year. Meanwhile, companies that operate in various economic sectors warned investors over the past few weeks that the pace of increase in their profits will likely slow, or that their profits will decline, during the months ahead as a result of dwindling sales to Europe and slower economic growth in China.

According to FactSet Research, 71% of the 102 S&P 500 companies that had issued Q2 earnings guidance as of July 6 estimate that their earnings either rose at a slower pace or declined during the quarter ended June 30. Meanwhile, analysts at Morgan Stanley reported last week that the percentage of companies that have lowered their second-quarter earnings estimates is the highest it's been since the summer of 2001.

Of utmost importance, companies that operate in the consumer discretionary sector account for the largest increase in the number of companies that have issued negative earnings guidance, and for the largest decrease in the number of companies that have issued positive earnings guidance, during the second quarter of this year, as compared to the prior quarter. That's a very negative development because it suggests that U.S. households reduced their spending on various types of goods and services during the past few months.

Meanwhile, the rate of increase in personal consumption expenditures has trended lower since September 2011. Those household expenditures declined during May, as compared to the prior month.

Personal Consumption ExpendituresClick to enlarge

In the event that households were to continue to reduce their spending, the pace of economic growth in the United States would likely decline further. That's because household spending accounts for approximately 70% of the U.S.'s total output of goods and services.

Although data on household spending for the month of June won't be available until July 31, last week's same-store sales reports issued by U.S. chain stores indicate that U.S. households continued to rein in their spending during June. For example, only 53% of chain stores reported an increase of 2% or more in their same-store sales during June, as compared to the same month a year ago. That's down from 71% of chain stores that reported an increase of 2% or more during June 2011 and down from 83% of chain stores that reported an increase in their same-store sales during May of this year.

With regard to overall economic developments, the latest readings on some very reliable leading economic statistics also indicate that the pace of economic growth in most regions of the world will continue to slow during the coming months. For example, purchasing managers at U.S. manufacturing companies announced on July 2 that manufacturing activity in the United States declined during June for the first time since July 2009, as new orders for manufactured goods fell 20% compared to the prior month.

ISM Purchasing ManagersClick to enlarge

Purchasing managers at companies that operate in the services sector announced on July 5 that economic activity in that sector of the U.S. economy continued to slow during June after peaking during February of this year. Separately, the University of Michigan reported on July 13 that the expectations of U.S. households regarding the future direction of the U.S. economy has fallen sharply since the beginning of June as a result of worsening conditions in the employment market and increasing concerns among high income households that government policies to bridge the so-called "fiscal cliff" won't be discussed by Congress until the last possible moment.

For those of you who aren't familiar with the fiscal cliff, that phrase refers to the conundrum that the U.S. government will face at the end of 2012 by being forced to either (1) raise tax rates and cut government spending in an effort to reduce the size of the U.S. budget deficit, or (2) cancel some or all of the scheduled tax increases and spending cuts in an effort to stimulate economic activity.

University of MichiganClick to enlarge

Commenting on the University's recent surveys of U.S. households, the Survey's Chief Economist said on June 29, "The sharp declines among upper income households ... may have a greater impact on the economy since their spending accounts for a large share of the total."

The economic expectations of small businesses remained at depressed levels during the past two months, with the National Federation of Independent Business (NFIB) announcing on June 12 that small business owners expect no improvement in overall business activity through the end of this year. The NFIB went on to say that "expectations for increasing future sales continued to be weak, far below readings recorded in any other recovery period since 1973." Meanwhile, 60% of small business owners said that now is a bad time to expand their businesses.

On July 10, the NFIB announced that only one of the 10 factors that compose its Small Business Optimism Index improved during June. A smaller percentage of small businesses said that they plan to increase the size of their workforce. Those factors and expectations suggest that the employment situation in the U.S. will continue to worsen during the coming months. That's because small businesses account for approximately 65% of all new jobs created in the United States.

The Economic Situation in Europe and Emerging Markets

In addition to the worsening economic situation in the United States, economic conditions in Europe and the world's major emerging economies of Brazil, China, and India also continued to deteriorate over the past few months. For example, sales at European retail stores declined for the second consecutive month during May, the latest month for which data is available, while industrial production at European factories fell for the third consecutive month. Meanwhile, the unemployment rate for the eurozone rose during May to the highest level in more than 15 years.

Although sales at Brazilian retail outlets rose modestly during May, after falling sharply during the prior month, industrial production at that country's factories, mines and utilities declined for the third consecutive month. While industrial production rose in China and India during May and April, respectively, those increases were very modest relative to the big declines in those countries' industrial production during the first quarter of this year.

Industrial Production in Brazil and ChinaClick to enlarge

Leading economic indicators for the eurozone and the emerging economies mentioned above suggest that economic conditions in those regions of the world will continue to worsen during the months ahead. For example, Markit's Purchasing Managers' Index for eurozone manufacturing companies declined for the fourth consecutive month during June, indicating that manufacturing activity in the eurozone will continue to decline during the coming months.

Separately, the economic expectations of eurozone households and German business executives continued to decline during June as a result of worsening economic conditions in Europe. Those are very significant developments for stock market investors because stock prices, in general, tend to trend lower when those leading economic indicators decline. With regard to the economic expectations of Germany business executives, those executives told the CESifo Group, a major European economic research firm, that their outlook for the eurozone economy for the next six months deteriorated considerably during June as a result of the increasing budget deficits that several European countries are experiencing.

Manufacturing companies in China reported last month that new orders for goods manufactured in that country declined during June at the fastest pace in more than three years.

Technical Indicators and Near-Term Outlook for Stocks

In regard to the near-term direction of stocks, the current readings on so-called technical indicators are giving some mixed signals at this time. For example, a larger number of stocks that trade on the New York Stock Exchange advanced in price than the number that declined in price over the past six weeks. That type of trading action, whereby the cumulative advance/decline line moves higher, usually indicates that stocks will trend higher over the near term.

Meanwhile, approximately 67% of individual investors think that stock prices, in general, will either move sideways or decline over the next few weeks, while only 33% of individual investors think that stocks are headed higher. Historically, stock prices have tended to rally whenever a negative divergence of that magnitude has existed between bullish and bearish/neutral investors.

In contrast, the most-recent reading on my Stock High-Relative-Price-Strength Index indicates that stock prices, in general, will trend lower during the weeks ahead. The fact that speculative stock market participants reduced their trading activity during each of the past three months also suggests that stocks will trend lower during the coming weeks. That's because stocks tend to move lower when speculative investors and short-term traders reduce their trading activity (see the chart below).

OTCBB Volume vs. NYSE VolumeClick to enlarge

Although many stock market participants became complacent over the past few weeks in spite of worsening economic data, my experience suggests that market participants, in the aggregate, will become much more concerned about the likely direction of stocks during the coming weeks now that the Federal Reserve has indicated clearly that it doesn't plan to implement another round of quantitative easing anytime soon.

In the event that market participants were to become more concerned about the future direction of stocks, many of those participants would likely reduce their stock holdings in line with a likely increase in the Chicago Board Options Exchange Market Volatility Index (VIX).

Mutual Fund Flows

The fact that mutual fund investors continued to withdraw large sums of money from stock mutual funds over the past four months also bodes poorly for the direction of stocks. That's because when those investors withdraw large sums of money from stock mutual funds, mutual fund portfolio managers tend to reduce their allocations to stocks. Because mutual funds account for a substantial amount of overall stock market trading, stock prices therefore tend to decline when mutual fund investors withdraw large sums of money from stock mutual funds.

Closing Comments

Although many economists, financial market analysts and money managers only recently began to realize that the pace of economic growth in most regions of the world would likely slow during the second half of this year, our research made us aware of that probability more than two months ago.

Meanwhile, our close monitoring of not only economic statistics, but also of several technical indicators and sector performance statistics has enabled us to advise our newsletter subscribers of opportune times to get in and out of the stock market. Although we don't expect our economic and stock market forecasts to always turn out to be correct, over the past five years our forecasts have been right much more often than they've been wrong.

In looking forward, I urge you to continue to be patient instead of taking unnecessary risks by continuing to allocate a large portion of your financial market assets to cash-like investments (i.e., money-market securities) and to inverse-equity ETFs. Although you won't generate any meaningful returns by investing in money-market securities, you'll be able to preserve the value of your capital while other stock market investors will likely have trouble sleeping.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.