Thursday, April 8, 2010

Earnings Season Is The Reason…

…not to sell your equity positions. At least not yet.

Based on the fact that a sufficient number of macro economic reports came in above consensus expectations during the first quarter, there is a high probability that 1Q10 earnings results will exceed earnings expectations in the coming weeks. And that appears to be more than enough of a reason for investors to sit tight with their equity holdings for just a touch longer.

Producing its second highest reading since being created one year ago, the Blue Marble Research proprietary Macro Economic Reports Indicator (MERI) registered a +8 for the first quarter of this year. The +8 number is second to the +12 reading for 2Q09, a quarter that resulted in well above consensus earnings reports for that quarter. Since most investors are of the bottom up stripe, waiting for the good earnings news should help restrain same investors from heading for the exits BEFORE the positive data is shared. The most immediate stock market relevance to the earnings reports is what happens to stock prices as the results are published. For those more bearishly inclined, the soon to be reported good news earnings season sets up a potential “buy on the rumor, sell on the news” scenario for stocks. However, on its own, such an occurrence is likely to NOT result in the long anticipated big correction (>10% in the US, >20% in higher beta markets).

Not Enough For The Big Enchilada

For something more substantial to occur to the downside in stocks, something more substantial needs to arrive on the scene to serve as the catalyst that brings into doubt both the sustainability of the bull market AND the economic handoff (from government spending to private sector growth) necessary for a sustainable economic recovery. There are many candidates capable of serving the role of stock market correction catalyst, with the leading prospect being rising long-term US interest rates. In this regard, the 10 year US Treasury rate is the prime suspect for the role.

As I noted in last week’s commentary, a rise in longer-term interest rates would produce a hit to valuation models that would be both direct and immediate. In its most simplistic form: rates up, P/E ratios down. Given the fact that so much of this bull market is anchored in the above average P/E ratio thesis (>15 times earnings, so justified due to low interest rates and low inflation), rising rates hold the potential of blowing a meaningful hole in that view – enough to take stocks prices down for the prescribed market correction amount (>10% in the US, >20% in higher beta markets).

What About Higher Growth Rates?

All fundamental valuation models identify two factors has having the largest impact on the present value of an asset – the discount rate (which includes interest rates) and the growth rate (of future cash flows/earnings). Accordingly, the offset to rising interest rates – rising growth rates – would most likely not occur as immediately as the bulls would argue due to concerns regarding the viability of sustained economic growth, as the aforementioned economic handoff will be brought into question courtesy the implications embedded in higher long-term interest rates. Regardless of what might be speculated re rising long-term rates, the very fact that rates are now on a upward glide path should be more than sufficient to raise the appropriate cautionary views toward equities.

Then there is the technical analysis hit to the market, as the upside move in rates would trigger a plethora of market technicians’ forecast of a major, multi-year head and shoulders bottom – with its measured upside move to 6%. As investors seek to make sense of the rising rate environment, market technicians will do their part in duly noting the message of the market – whatever it may be saying.

Our Old Friend The Shadow Banking System

Another equally important candidate for the catalyst role would be a global version of the Greek fiscal drama currently underway. As the lack of transparency in the sovereign and other debt markets (which I would include US states and other governmental municipalities throughout the world in that mix), just who is on the hook for what remains shrouded in the shadows (as in the shadow banking system). Such as point was noted quite articulately in yesterday’s FT commentary by Ken Rogoff.*

Investment Strategy Implications

To some investors, what I described above could easily be perceived as an attempt to squeeze out a few more basis points from the overvalued, long-in-the-tooth stock market stone. Such thinking may actually turn out to be correct. However, absent a catalyst it is hard to envision what could derail the bulls momentum.

Given the massive amounts of cash still sloshing around the world economy and financial markets, the strong economic health of most businesses, globalization damaged but not broken, and the global growth story still fairly intact, it appears logical that something more substantial will be needed to bring into doubt the bullish case. And that is what market corrections are all about – doubt that what was will resume.

For such doubt to arise, a catalyst is most likely needed to trigger the requisite angst that is the hallmark of a stock market correction. In this commentary, you have the two leading candidates for that role. There are others.

This is not a matter of if but when (and who).

*”Bubbles Lurk in Government Debt”, Financial Times, April 7, 2010.

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