Those who left for vacation last Thursday maintaining a long S&P 500 position will arrive home this weekend to find that the index went virtually nowhere since their departure. "There must not have been much going on", they might say. But after what can only be described as a volatile week for equities, the S&P 500 finished out the day at 1,102.66, up 0.82% for the day and nearly 3.55% for the week. Since last Thursday, the index saw closing prices deviate from their previous closes by at least 1.25% in four of the six trading days. It may be summer, but the light volumes (3.9 billion shares on the S&P's today) continue to allow the market to gyrate wildly day to day. It's truly a trader's market.
Not surprisingly, traders who left for vacation long Treasuries are also coming home to a market that appears to have gone nowhere. After seeing yields drop below 2.90% on the 10-year Treasury bond just two days ago, rates backed up nearly 6.8 basis points today to close at 2.9998%. While still below the psychologically important 3.00% level, there is little doubt that investors are looking at the positive earnings reports that have been released as well as the rosy conclusions of the European bank stress tests as signs that the economic outlook is less dire than once thought. The fact that Hungary has been put on watch by Moody's and Standard & Poor's for a potential reduction in its credit rating did little to undermine the conclusions of the stress tests.
Strong corporate earnings from companies like McDonald's, Ford, and Honeywell continued to provide the fundamental data the bulls needed continue the July rally. While I still remain skeptical about the ultimate level of earnings in coming quarters (I outline my reasons below), it's getting harder and harder to deny that both the reported numbers and outlooks provided by management are generally upbeat. As such, the equity market appears to want to move higher as it finally closed above the technically important 1,100 level today. We’ll see on Monday if this move was simply a bit of gamesmanship from the trading floor trying to shake out the last of the remaining shorts (they shook me out of mine today) or if this is really a sustainable breakout. As I am still fundamentally bearish, it was hard to cover my short position today. However, the earnings momentum of late has been so strong that investors are willing to ignore virtually all the negative macroeconomic news that’s been released. In that type of environment, it’s better to simply stay out of the way and look for a turn in sentiment. As September is normally a challenging month for equities, I’ll be looking for the rally to continue for the next 30 days or so before reconsidering my short. For now, I’ll be hiding out in cash for the most part. I’ve got a little TIPS (Treasury Inflation-Protected Securities) exposure as a hedge against any sudden (and unexpected) spike in inflation, but that’s about it.
As you’ve read my previous posts, I have real concerns about the prospects for the U.S. economy over the next 18 months. Uncertainty around tax rates, financial regulation (Yes, the financial regulation bill was passed, but the effects are not as yet fully understood.), consumer spending, and job creation are likely to present real challenges to growth and keep us teetering between recession and expansion. In such an environment, how are earnings at the country’s major corporations likely to fair? For my part, I believe that companies will have a great deal of difficulty expanding both revenues and profits in such an environment. Below are just a few of these reasons why.
- Limited Effectiveness of Cost Cutting: Corporations around the world have become masters in the art of controlling costs. If 2008 and 2009 showed nothing else, it’s that companies were able to trim their operating expenses in greater scale and in a shorter amount of time than many believed possible. As a result, firms were able to largely offset, or at least reduce the effects of, the revenue declines that were experienced during this time. This was nothing short of impressive. However, as we begin to move into the new economic paradigm that has resulted from the tumultuous days in October 2008, the ability of firms to expand earnings purely from expense reductions is greatly reduced. For many, I suspect, this isn’t even an option at this point as all the fat has been trimmed. This means that revenues will have to grow in order for earnings to improve. In a deteriorating economic environment, this is not likely to happen. In a stagnant economic environment, this isn’t likely to happen. This leaves only robust economic growth as the mean for companies to improve earnings. It’s possible that this latter scenario materializes, but I have my doubts.
- Growth Largely China-Based: U.S. companies, for the most part, are now globally focused entities. Revenues and earnings are as much a function of the economic climate in Europe, Asia, or the Middle East as they are here at home. As a result, firms are able to alleviate much of the volatility in their earnings through this geographic diversification. As one country slows, another should be growing, thus reducing the impact on earnings. And while this is good in theory, the scale of the global economic slowdown in 2008 and 2009 showed that the world is much more economically interconnected than originally thought. Interestingly, though, China’s economy has remained relatively robust despite a sharp slowdown in 2008 and has reclaimed its title as one of the world’s largest and fastest growing economies. This growth has flowed directly through to companies’ bottom lines. Virtually all the commentary from corporate managers in Q2 has noted the strong demand for goods from China as one of the primary underlying drivers of their revenue and earnings growth. This implies, to me, that firms are becoming increasingly reliant upon the Chinese economy as the means to grow revenues. This singular focus adds a great deal of country-specific risk that is not being fully appreciated. And with the concerns that many (including myself) have about the actual health of the Chinese economy in the event that there is even a small slowdown in real estate values, the prospects for continued corporate earnings look all the more uncertain.
- Rising Capital Costs: Lastly, I believe that corporations have benefited a great deal from the Federal Reserve’s easy monetary policies. Most have restructured their capital mix to take advantage of the market’s willingness to provide lower cost capital at longer maturities. As a result, liquidity has been greatly improved. However, if the economy falters, firms are likely to see their borrowing costs rise precipitously as investors shun corporate issues for safe-haven securities like Treasuries. This would undermine much of the cost-cutting benefits that have resulted from this low interest rate environment. Furthermore, new projects and additional capital spending would likely be constrained as the return thresholds needed to undertake such activities will rise along with the cost of capital. This would not bode well for earnings across the board.
It’s been a crazy week. Unfortunately, my short S&P trade didn’t play out as planned, but I’ll at least live to fight another day. I’m looking for continued positive earnings news for the most part next week and for the rally to continue apace. If I had more fundamentally bullish conviction, I’d try to flip around and play this from the bull side, but, for me, the risk isn’t worth the potential reward. In the meantime I’ll continue to be watching the interplay of the dollar and Treasuries along with the commodities sector. I wouldn’t be surprised to see energy prices move up over the next month as seasonal trends are on the bulls’ side and a rally in equity would no doubt spur optimism in the level of demand for such assets. I’m looking forward to seeing how it plays out and if there’s a trade to be made along the way. I hope you all have a great weekend and I’ll see you back here Monday evening.
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