“Which Way Should I Go?”[i]

After years of stock prices steadily moving from lower left to upper right, the recent trend breaking decline has bulls and bears struggling as they frantically determine the stock market’s next direction.  The debate centers on whether this is just the long awaited correction or the start of a bear market.  And this will be determined by the direction of the economy.

The capital markets continually digest the ongoing flow of news, data, and corporate earnings.  This is part of the discounting and forecasting process that ultimately helps set prices. But this latest turmoil has brought forth additional issues into this valuation process.

These developments include volatile foreign exchange markets with several devaluations – the most significant being China.  This has further strained the emerging markets economies which have been in retreat for over a year.  Also, the U.S. has recently coughed up some soft data and yield spreads are widening.  Importantly, corporate earnings are facing some stiff headwinds.

The events concerning China, the world’s second largest economy, are both straightforward and complicated.  The obvious is a slowing growth.  Much of the infrastructure needs have been met and demand for housing has peaked which has shelved construction projects.  The ripples from this have traveled throughout the world contributing to the emerging economies’ slowdown.

China’s currency devaluation is something that involves more complications and uncertainty.  First the Peoples Bank of China (PBOC) gave no hint or any forewarning of the move so the markets were caught off guard.  Secondly, it came after the Chinese stock markets collapsed during the summer as stocks plunged over 40% in two months.  Finally, implementing the change was an administrative disaster.  The PBOC waited more than 48 hours after announcing the new currency peg until having a press conference.

This delay provided an opportunity for the rumor mill to shift into high gear.  The conjecture included that the devaluation was for international competitive reasons, it was a panic move to deal with a slowing economy, China was encountering a liquidity crisis, and fears of a 1930’s-type civil war.

Investor’s reaction, as would be expected, was to sell first and sort out the details later.  As everyone looked to de-risk, global stock markets fell, the dollar and bond prices (lower interest rates) rose, and precious metals caught a bid (or at least they stopped going down).

During the selloff, the major averages across the world gave back their year-to-date gains and turned negative.  In fact most major global indexes were lower for the past 12 months (as measured in U.S. dollars).  Furthermore, the MSCI All Country ex-US index (a broad world index that removes the U.S.) recently reached a two year low.

The challenge now becomes factoring these events into current prices and future expectations.  Of course, there is the possibility that these developments are nothing more than speed bumps and that everything returns to the “normal” of recent years.  This is likely an unrealistic dose of wishful thinking because of how much the landscape has changed.

China wasn’t the only country to devalue their currency – Kazakhstan and Vietnam (3 times in 2015) both cheapened their currency in dollars terms.  Besides this foreign exchange turmoil the markets have seen bond yield spreads widen (as compared to U.S. Treasury bonds).  Specifically, corporate bond yields have pushed higher as Treasury yields have remained at around the same level.  This means that the markets have adjusted their view of the safety of corporate bonds.

This has partially been caused by the fall in energy and commodity prices as many drillers, miners, and suppliers of raw materials finance themselves by issuing bonds.  As the prices of the products they sell have fallen, their revenues have dropped and the markets have viewed their bonds as more risky.

Furthermore, corporate profits have leveled off an, in many cases, have declined somewhat.  The stronger dollar has contributed to this as companies with international sales see a reduction as those foreign sales get converted back into U.S. dollars.  For an example of how this is impacting U.S. corporations, we look at the S&P 500 which is comprised of the largest companies most of which have substantial international business.

The total earnings per share for the second quarter earnings reports were 3.2% less than 2014’s second quarter earnings per share.[ii]

Unfortunately, this trend seems to be continuing as we are in the heart of third quarter reports.  Assuming the pattern of the first two weeks carries on, it will be another lower quarterly earnings for the S&P 500 – Thompson Reuters is forecasting a 2.8% decline.  The disturbing significance of this is that the only other times that we’ve seen multi-quarter negative earnings during the last 25 years, stock prices have fallen dramatically. The examples are 4Q 2007 through Q3 2009, Q1 2001 through Q2 2002, and Q1 1990 through Q2 1992.[iii]  All were accompanied with painful stock market sell offs.

Despite year-over-year earnings being negative, October\has been a pretty good month with the S&P 500 advancing 8%.  This has the index back on the positive side of the year-to-date ledger. Despite a strong end of the week, the Dow narrowly missed getting positive YTD.

Here are the major averages 2015 performance.

                               

The October rally has been in spite of soft earnings and economic data.  Last week, for example, U.S. equities rallied strongly (478 Dow points on Thursday and Friday alone) predominately on news from Europe and China.  First, the European Central Bank announced further easing and promised to move interest rates, which are already negative, even lower.  Second, China’s central bank unexpectedly cut the required reserve ratio for banks and lowered both lending and deposit rates.

On one hand, lower interest rates (for longer) and more quantitative easing is a Halloween treat for the markets.  The potential trick is that the global economies are in need of more stimulus.  As Mohamed El-Erian summarizes, “Markets are right to welcome the China news as confirmation that the Fed, the ECB, the People’s Bank of China and other central banks remain their best friends. But what markets really need is a transition away from this liquidity assistance, toward genuine growth.”[vi]

It was not all central bankers last week, there was some help from corporate earnings.  Amazon, Google (Alphabet), and Microsoft had strong earnings reports on Thursday and each opened 8.5% higher on Friday.  Last week marked the fourth consecutive weekly gain for U.S. stocks and has brought the indexes back to the August levels just before the decline started.  However, there will likely be resistance at these levels as well some time needed to digest October’s jump.  Price action over the next couple of weeks should help indicate the direction into year end.

Although there has been some soft economic data (ISM survey, rising inventories, retail sales, etc.), there are still some rays of light.  Jobless claims are at 40 year lows.  Last week weekly initial claims were reported to be 259,000.  This was the second straight week of a sub-260,000 reading which hasn’t happened since 1973.

The job market is a focus of the Fed as they consider raising interest rates for the first time in 9 years.  Of course, the Fed’s interest rate decision has become a monthly reality show as every financial media outlet spends days of debate, interviews, predictions, and analysis on the event.  The markets are reaching a point of fatigue on this and Janet Yellen risks losing the markets’ confidence in her ability.  On the other hand, the Fed’s decision will have an impact beyond the U.S. and they must consider what a rate increase will do to fragile international economies.  Finally, after the decision to raise rates is behind us, the pace of any future increases will be important.  Likely, by all indications, the speed will be very, very deliberate.

Despite all of the talk of higher interest rates, U.S. yields have drifted lower from the summer’s levels.  The 10-year treasury traded around the 2.45% level in July but has retreated to below 2% earlier this month.  At the other end of the spectrum, however, things have priced in the decision and moved higher.  For example, the yield on a 6-month CD back in June was 0.25%.  Now it is 0.55%.  Noteworthy, the 1-year CD has not adjusted as much.  A 1-year CD yielded 0.45% in June and now is at .55%.  It would seem that this market has priced in an interest hike within six months but nothing beyond.

Market watchers have been looking for a correction for over 4 years.  We finally got it in August.  Unfortunately, we don’t know whether October’s rally signals a resumption of the longer term bull move or whether another leg lower is forthcoming.  The currency turmoil and damage done to the international economies, especially emerging markets, should not be ignored.  From a seasonal perspective, November and December are a historically strong period.  Corporate earnings (and forward guidance) should be the best answer to how the markets’ direction ultimately gets resolved.  Trick or treat indeed.

---