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Figure 1: On May 17, 2012, the bull-bear spread fell to -22.4ppts; on June 9, 2011, the bull-bear spread fell to -23ppts and bounced along that low a couple more times before the S&P 500 finally bottomed on October 3, 2011

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On May 17, the bull-bear spread (i.e., the difference between the bullish and bearish percentage) fell to -22.4 percentage points (figure 1). Historically, the stock market tends to put in some kind of a bottom when the bears are looting and the bulls have completely pulled in their horns. The question is: Will it be a temporary reprieve, or something more durable? Last spring, the bull-bear spread 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. If past is prologue, we may have just embarked on a bumpy ride that could last all summer long. Buckle up.

Talley D. Léger
Investment Strategist
(203) 940-0878

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

Figure 1: Among the 60% of S&P 500 companies that have reported operating EPS for 1Q12, 70% beat, 19% missed, and 11% met their estimates

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Figure 2: Mean reversion - the beat rate has moderated to 70% (as of April 26)

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Last week, we noted that this quarter's beat rate of 80% (as of April 19) was unusually high compared to the five-year average of 67%, just as last quarter's beat rate of 49% (as of January 19) was unusually low at the same point in the reporting period (figure 2). 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. However, Q1 estimates stopped decreasing on March 18 and have started increasing, meaning further significant positive surprises may be harder to come by (read: mean reversion). Indeed, the beat rate has moderated from 80% to 70% (as of April 26).

We've always questioned the efficacy of earnings surprise models. To us, it seems the surprise says more about the instability of the estimates than it does about the underlying trend in earnings. In our view, it's the trend in earnings growth that matters most for equity returns. Figure 3 shows the year-over-year percent change on S&P 500 trailing 12-month operating EPS alongside the year-over-year percent change on the S&P 500 index since 1990. On a trend basis, equity returns usually benefit from accelerating earnings growth, and generally suffer from slowing earnings growth. S&P 500 quarterly operating EPS grew 16.4% y/y in 1Q11. So far, EPS are growing 7.8% y/y in 1Q12 according to Capital IQ's bottom-up consensus estimate (figure 4). The point we're trying to make is earnings support is waning for stocks on a trend basis.

Figure 3: On a trend basis, equity returns usually benefit from accelerating earnings growth, and generally suffer from slowing earnings growth

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Figure 4: So far, EPS are growing 7.8% y/y in 1Q12, meaning earnings support is waning for stocks on a trend basis

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Last spring, we had a "minor" Greek tragedy while Euro Area real GDP grew 0.8% q/q in 1Q11. This spring, we have a major Spanish and Italian Inquisition while Euro Area real GDP entered recession for the second time since the start of the financial crisis, falling -0.3% q/q in 4Q11 and the momentum isn't looking good for 1Q12 (figure 5). Last 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. This week, we learned that Spain (the fifth largest economy in Europe) real GDP shrank -0.3% q/q in 1Q12. Meanwhile, Standard & Poor's has downgraded 11 banks, including Santander (STD) and BBVA (BBVA), adding to its two-notch downgrade of Spanish sovereign debt last week.

As we noted last week, 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. 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. Caveat emptor.

Figure 5: Euro Area real GDP fell -0.3% q/q in 4Q11 and Spain (the fifth largest economy in Europe) real GDP shrank -0.3% q/q in 1Q12

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Figure 6: S&P 500 Sector Performance (April 27, 2012)

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Talley D. Léger

Investment Strategist

(203) 940-0878

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

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Consider the relationship between the VIX and the Fed's Trade-Weighted U.S. Dollar Index: Major Currencies. Clearly, flight-to-safety flows typically benefit the U.S. dollar at the expense of other major currencies, which also takes some of the shine off the broad commodity complex as measured by the Thomson Reuters / Jefferies CRB Index.

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Meanwhile, 10-year U.S. Treasury bonds generally outperform the S&P 500 during such risk-shedding events. At the same time, these trends usually correspond with wider credit spreads as expressed by BofA Merrill Lynch U.S. Corporate Master Option-Adjusted Spreads. In other words, flight-to-safety flows typically favor Treasuries over investment-grade corporate bonds (i.e., those rated BBB or better).

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Volatility trends are inversely correlated with the relative performance of several other higher-beta asset categories, including high-yield corporate bonds, small-capitalization stocks and economy-sensitive sectors of the equity market (i.e., Financials, Consumer Discretionary, Technology, Industrials, Energy and Materials). Widening quality spreads (i.e., the difference between high-yield corporate bond spreads and their investment-grade counterparts), the outperformance of the S&P 500 versus the Russell 2000, and the leadership of large-cap defensive sectors (i.e., Health Care, Consumer Staples, Utilities and Telecom) makes sense in the context of heightened market turbulence because investors' appetite for risk (or lack thereof) is a key driver of their overall risk posture.

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Another way to think about these relationships is economic beta: Higher-quality, larger, defensive companies are more insulated from an eroding economic outlook than their lower-quality, smaller, cyclical brethren. From our lens, the trajectories of C&I loan growth, the 2s10s Treasury yield curve and the VIX suggest the recent outperformance of lower-beta assets is just beginning. Stay sharp.

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

Figure 1: VIX vs. SPX

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Figure 2: 2s10s vs. VIX (Long)

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Figure 3: 2s10s vs. VIX (Short)

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Figure 4: C&I vs. VIX

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Enjoy,

Talley

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