Balance Of Fundamentals Will Continue To Weigh On Market

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Includes: AAPL, DIA, GS, INTC, IWM, IWV, MSFT, PEP, QQQ, SPY, T, VZ
by: James A. Kostohryz

As I have stated previously, I believe that the US equity market (^GSPC, ^DJIA, ^IXIP, ^NDX, ^RUT, ^RUA) will remain essentially range bound until there is either positive or negative resolution of one or more of the main fundamental factors that have been driving the market.

Let us review six key fundamental factors as well as the technical panorama:

1. Sovereign debt and financial crisis in Europe.

2. Economic growth momentum in the USA and prospect of “double dip.”

3. Corporate earnings reports and guidance in the USA

4. Fiscal policy in the USA.

5. US monetary policy.

6. Global growth, with particular emphasis on China.

7. Technical factors

Let us now examine each issue individually.

Crisis In Europe

Nothing has changed in Europe. European leaders have been jawboning the markets up with vague talk of assisting the banks, but so far, no credible plan has emerged. Only bold measures will suffice, but for now, they are opposed by the Germans and other northern Europeans.

The key to the whole European crisis is the sovereign bond markets. In this regard, last week, the sovereign bond spreads of Spain and Italy showed no substantial signs of improvement. At 5.2% and 5.7%, the 10Y yields of these Mediterranean giants remain at remain at precariously high levels. In addition, the spread of French bonds to Bunds actually widened with the yield on French 10Y notes actually surpassing the 3.0% level.

Thus, the definitive indicator regarding whether the crisis is abating in Europe is actually flashing a red light.

Growth Momentum in the USA

Growth indicators have generally been registering better-than-expected readings. I actually believe that due to the effects of pent-up demand discussed here, US economic numbers may continue to rebound in the next month or so.

Having said this, this positive effect will only be temporary unless the dreadful levels of consumer and business sentiment improve.

Allow me to expand for a moment on the importance of psychology to the current economic outlook. It is clear that US growth momentum has decelerated due to shocks to sentiment. It is possible that these sentiment shocks will only have temporary consequences. Indeed, I believe that it is still possible for these sentiment effects to be reversed. However, it is my view that if decisive policy measures are not enacted soon in Europe and the US, the poor sentiment will translate more permanent lowered expectations. This will result in lower levels of consumption and investment.

In sum, growth momentum may be a supporting factor for the US equity market plus in the short-term (1-2 months). However, on a 3-4 month time-frame the outlook is less sanguine unless convincing policy measures are enacted in Europe and the US.

Earnings Reports and Guidance

Earnings have been revised downwards at a record rate during the entire third quarter. I have no strong opinion whether expectations have been lowered sufficiently relative to the third quarter numbers that will actually be reported.

The earnings season kicks off in earnest this coming week.

If the earnings numbers are worse than expected, that will clearly be bad for the market. If earnings are better than expected, that might generate some upside. I say “might” because, ultimately, surpassing earnings expectations for 3Q won’t matter if companies issue lowered outlooks and guidance for future quarters. This will be the key.

It is my opinion that the outlooks and guidance issued by managements will be cautious. In particular, I believe that management outlooks for non-US sales may be particularly affected. Many analysts and investors tend to be too US-centric in their forecasting. However, foreign sales constitute well over 30% of S&P 500 sales and roughly 50% of earnings. Foreign sales and margins is where I think that the negative surprises could mostly come from.

Fiscal Policy in the USA

The US budget deficit registered $1.3 trillion in fiscal 2011, which was actually an increase from the $1.29 trillion recorded in 2010.

As a percent of GDP, the budget deficit for fiscal 2011 was 8.7% -- barely down from 9% percent in 2010 and 10% in 2009.

In the short-term, the situation can be actually be managed without much stress. Interest expense as a percent of GDP is extremely low – and it will remain quite manageable even if interest rates normalize.

The problem is that longer-term budget projections are frightening. Markets need some sort of reassurance that the long-term deficit will be dealt with. Otherwise, actual and projected deficits are at levels that cannot be sustained without provoking either a sovereign debt crisis and/or an inflationary crisis.

Is there any prospect that the Super Committee will pass a plan that will make the US fiscal position any more credible? Highly unlikely. The current level of deficit cuts being contemplated – and which will likely generate a great deal of political and financial market stress before they are actually passed – will not even shave one percentage point off of projected annual budget deficits as a percent of GDP.

Thus, the US fiscal situation will likely remain an irritant for financial markets for the foreseeable future.

US Monetary Policy

Operation Twist is irrelevant, at best. US monetary policy must be much more aggressive and creative to make any sort of impact on the economy. However, Chairman Bernanke is unlikely to proceed with such measures without near unanimity within the Committee.

Recently strengthening economic numbers actually assure that the US Fed will be marginalized for the next for the next three to four months.

Global Growth

Global growth is decelerating. The deceleration has been severe in some places, such as Brazil. In China, hopes are high that authorities will manage to engineer a “soft landing.”

I am less sanguine about Chinese growth than many, but not nearly as bearish as Jim Chanos and other China alarmists.

Why am I somewhat bearish regarding China in the short-term? Notwithstanding efforts to debt ut, China’s economy is highly export-dependent. The deceleration of global growth, and particularly the growth of Europe which is China’s largest trading partner will have a major impact on China’s economy.

In the short-term (1-2 months), China may actually see some benefit from the normalization of Japanese supply lines that have been reestablished. However, once this effect has passed, my prognosis is for a rather sharp deceleration.

The deceleration of activity could be particularly acute given significant excesses in the formal and informal credit markets in China where lending activity has led to substantial misallocations of resources. The unwinding of these excesses will involve pain.

So why am I not more bearish? China has massive fiscal and monetary resources at its disposal and it still has an extensive command-economy structure that can put money to work rather quickly. Thus, as soon as economic deceleration reaches a certain level, Chinese authorities will act decisively. This is even truer since key national elections are around the corner.

Thus, global growth, and Chinese growth in particular, are net negatives for US stocks on a 1-4 month time-frame. Longer-term, I think it would be a mistake to become overly bearish.

Technical Analysis

US equities (SPY, DIA, QQQ, IWM, IWV) briefly broke below their range on the downside. By the same token, it is possible that US stocks could briefly break above their range on the upside, without alterning the range-bound nature of the current market. The upper end of the recent trading range is 1,232, buttressed immediately by the closely-followed 200-day moving average which is currently at 1,235.

S&P 500 Chart

If the upper level of the trading range -- 1,232-1,235 on the S&P 500 -- is broken, the first and probably strongest level of resistance will occur in a band between 1,248 and 1,257 on the S&P 500. Horizontal resistance lines coincide with a two-thirds retracement (1,257) of the recent decline (starting at the 1,348 level in late July). A break of 1,232 that was contained below 1,257 would provide symmetry to the recent false break on the downside – thereby maintaining the range-bound characteristic of recent market action.

The next resistance would occur around the two-thirds retracement of the entire move since the peak of 1,371 in late April which equates to 1,272. This level also coincides with horizontal resistance from the mid-June low that was established between 1,260 and 1,280.

Conclusion

I believe that the US market is likely to remain range-bound until there is upside or downside resolution of one or more of the key fundamental issues that have been driving the market in recent months.

In my view, the balance of fundamentals will continue to weigh on the market and provoke a retest of the 1.075 lows within the next 1-4 months. Indeed, based on my assessment of likely evolution of the various fundamental factors, I believe that an ultimate test of 950-1,020 is likely.

In my view, the current upside reversal has mainly been driven by massive short-covering rather than any serious fundamental change in conviction on the part of institutional investors. Indeed, I believe that many institutional investors will welcome the opportunity to reduce exposure if the market were to break above the 1,232 level that has recently defined the upper end of the trading range. I believe that such institutional cash-raising could serve as a strong source of strong overhead resistance in the next 1-4 month time-frame.

I have my eye on stocks such as Apple (AAPL), Microsoft (MSFT), Intel (INTC), AT&T (T), Verizon (VZ), Pepsi (PEP) and Goldman Sachs (GS) which I believe will ultimately be available for purchase at prices 15%-25% below current levels.

Disclosure: I am short TLT.