Second quarter 2012 has a strong chance of being the first reporting period since 2009 in which earnings decline year over-year. Since 2010, quarterly earnings have easily performed above expectations. In my opinion, that shouldn't come as a surprise; most companies, if not all, tend to understate forecasted earnings guidance and then beat on low expectations as a means of protecting their stock prices. That notion works well in a "growth mode" environment but the overall rate of earnings growth is no longer at double-digit levels, as it was from mid-2009 through the end of 2011. Since the start of the second quarter (March 31), the earnings growth rate for the S&P 500 index has declined to 2.1% from 6.5%. All ten sectors have recorded a decrease in earnings growth rates during this time, led by the Energy and Financials sectors.
Despite the fact that earnings expectations were lowered and many companies are yet again "beating the street," we are more concerned with sales growth moving forward. In other words, if revenues aren't increasing, earnings per share can't grow and stock prices eventually adjust. As companies report earnings, regardless of their competitive advantages, they operate within the global economy and are not impervious to its vicissitudes. Indeed, companies are beating on the bottom line but appear (broadly) to be missing on the top line.
Furthermore, guidance appears negative; 99 negative EPS pre-announcements issued by corporations for Q2 2012 compared to 30 positive EPS pre-announcements. This gives us an N/P ratio of 3.3 for the S&P 500 Index - the weakest showing since Q4 2008. Results have been disturbing on the top line as well with 57% of those reporting revenues thus far coming in below expectations. I view this as another potential recession indicator - we saw the same surge in negative revenue surprises in 2008.
In addition to the earnings season, markets will be coping with other policy issues and data points. Until a few days ago, news from Europe had been quiet, which usually means that no bond market blow-ups are imminent. That changed over the weekend as Spanish bonds rose to 7.5%. The flash estimate of Euro Area consumer confidence fell in July to its lowest level since August 2011. The Eurozone PMI has moved deeper into recession territory (44.1). Markets tried to rally on the flash China manufacturing PMI data this week; it came in at a five month high of 49.5 with the press saying that earlier rate lowering and easing measures are starting to work. Five month high or not, one report is a long way from reversing the current trend.
Being a Presidential election year, it might be useful to look into the history books for a little clarity on market performance during these times. The economy has a tendency to do poorly in the first two years of a Presidential cycle followed by strong growth and recovery in the second two years. Since the early 1900s, it has been common practice for the incumbent administration to do whatever it takes to ensure a prosperous economy and growing stock market are in place leading up to election time. This so-called "pump-priming" typically includes increased government spending, low interest rates, tax cuts, and even tax rebates.
In doing so, businesses are encouraged to increase capital spending and hire more workers. Consumers are encouraged to open their wallets and let the good times roll. Such measures may not be likely since those bullets have been fired for the last three years. Political parties learned a long time ago that economic conditions were a critical factor in garnering votes. Regardless of how many other positive factors exist, few incumbents have been elected if the economy is struggling come voting day. Perhaps change is needed once more.
No matter how many times an election year has brought positive returns, the characteristics of the current market are simple; up, down, up, down with a bias towards down. This see-saw action is referred to as "moving sideways" and is often foretelling of a directional change. Another useful metric for determining market direction is insider buying and selling. Executives tend to have a much better understanding of how their companies are doing and more importantly, how they will be doing. Last week, corporate insiders sold stock in their companies 3.30-times as often as they purchased shares. Taking a broader view, insider sentiment has been within bearish territory for five consecutive weeks - after being bullish from late May to early June. Though insider buying is generally a better indicator than insider selling, the current elevated level of selling among insiders is worth noting.
Also worth noting is the 10-year treasury yield plummeting to new lows. Clearly, with yields reaching 1.40%, investors are categorically fearful of something. Corporate bond yields also declined but not as far or as quickly. Consequently, the spread between Treasuries and corporate, now at more than 2.00%, widened in the last few weeks. From an investment standpoint, we continue to think corporate bonds offer relative value, as corporate balance sheets, flush with cash, generally appear to be strong. From an economic standpoint, we watch the spreads closely to gauge the bond market's view of corporate financial strength. Despite the widening spreads, corporate default risk remains low at present as many companies are able to access credit from markets that remain open. However, these recent changes give us reason to monitor this situation more closely.
All of this is a reminder of the extreme seasonality we have seen in the past two years. As the weather heats up, the market seems to cool down; sometimes gradually and sometimes harshly. During the 2Q11 reporting season, already precarious investor sentiment crashed to the ground; 2Q11 results hardly seemed to matter amid the paralyzing partisan divide in Washington. A year later, the intense partisan divide is a given. Maybe that will allow investors to focus on actual second quarter results and third quarter guidance and stop wishing for another "prop-up" by way of QE3; printing money only prolongs the inevitable.
The Bottom Line: Last week's economic indicators were mixed and the majority of data was disappointing. As second quarter earnings go, most companies are generally beating lowered expectations but missing on the top line and guidance is unclear to lower. The recovery is not as strong as it had been at the beginning of 2012 even though it never was robust. Leading indicators have turned negative, adding to the view that the economy is grinding to a halt. The index fell 0.3 percent in June after a 0.4 percent boost the prior month. Weighing on the June number were the new orders index, consumer expectations, building permits, jobless claims, and new orders for non-defense capital goods excluding aircraft.
To avoid further slowing, consumers will be forced to dig deep and find reason to spend. Retail sales have slowed and the consumer sector has lost momentum with total sales excluding autos and gasoline in negative territory for the trailing three months. As I have mentioned in previous reports, the consumer makes up approximately 70% of our nations GDP. Adding to the detriment of consumer spending is expiring tax cuts come year end. Of course, politicians could get their act together and resolve this part of the looming "Fiscal Cliff."
Turning to technicals, the market rally since mid-May still leaves the S&P 500 well below the cycle high 1,422. In spite of this, higher highs and higher lows are the textbook definition of a bullish trend. However, a missing and very important ingredient is breadth. Discerning breadth can best be measured by the percentage of stocks trading above their 200-day moving averages; based on a 10-day trend-line, stocks have moved from a low near 40% early in June to the 52% level currently. Stocks are pointed in the right direction, but sustainably advancing (Bull Markets) markets usually show two-thirds of stocks above their nine-month moving averages. Even more concerning, U.S. indexes continue to decouple from foreign exchanges.
At present, China and Spain should be considered leading indicators; since peaking, these two have fallen no less than 60%. In stark contrast, the S&P 500 needs only 10% to reach all time highs. Are we immune to the global crisis or did QE1, QE2 and Operation Twist add hot air to this balloon ride? The European Top 100 Index failed near resistance and broke a rising channel trend line on Monday. This, in our opinion, signals a continuation of the March-June decline which is bad for the S&P 500 given their strong correlation. At the same time, Consumer Discretionary is showing relative weakness, thus underscoring the slowing economy.
In summary, we are convinced that risk is greater than the potential reward. The U.S. dollar appears poised to keep running (higher) and world markets are failing to rally. We have a Fiscal Cliff ahead and Europe cannot produce a tenable or executable plan. With economic data slowing, unemployment remaining at elevated levels, and 10-year Treasury Yields at historical lows, we are maintaining approximately 35% allocated to cash until fundamental and technical data show sustainable improvement. We continue to prefer corporate over treasuries on a relative basis, large cap versus small cap stocks, domestic versus international stocks and some emerging markets.
The mood of this market is suggesting further downside coming and maybe just around the corner. I realize this may look like the perfect contrarian opportunity, but don't get trigger happy yet.
Additional disclosure: This information does not constitute a recommendation of any kind. All information contained herein is for informational purposes only and does not constitute a solicitation or offer to sell securities or investment advisory services.
