Market Memo: Reducing equity overweights
Economy, markets grind forward as Europe heads to the beach and election uncertainty builds
As July fades into August, equity markets have enjoyed a remarkable bounce off the June lows, now up nearly 8%. Remarkable, because the news flow since early summer has been uninspiring. Earnings season has been muted, with the majority of companies beating on the bottom line but missing on revenues. Economic news out of Europe has worsened, with the U.S. clearly entering a soft patch, at best. The probabilities of both a Greek exit from the euro, and a full-scale Spanish sovereign bailout, have risen. The U.S. presidential election, while heating up, remains so close that markets are increasingly bracing for a Nov. 6 nail-biter. And amidst the summer haze, the collective leadership of Europe’s banker, Germany, has headed out for its annual beach holidays, promising to return sometime late in August. None of this is particularly appealing to us, so we’ve used this week’s rally in equities as an opportunity to pull back on our recommended Prism overweight to equities, from 700 basis points to 400 basis points, sticking the entire proceeds into cash. While we remain positive on the long-term secular bull market in equities, this move is meant to signal our view that we see the near-term outlook as, at best, more balanced between downside risk and upside reward.
Earnings season bummer
Entering the second-quarter earnings season, we were hopeful for relatively good news that would result in additional upgrades of expected full year earnings towards our above-consensus $110/share estimate on the S&P 500. So far, that hasn’t happened. With 68% of companies reporting through this morning, 66% have beaten on the bottom line but only 33% on the top line. On average, analyst earnings estimates for the full year have increased by 0.2% since quarter-end, after declining 3.3% in three months prior. Although earnings news seems to vary widely by company (a good thing for us stock pickers, by the way), some general trends seem apparent: China remains soft, Europe weak and the U.S. consumer uncertain. And the strengthening dollar, driven largely by investors retreating from Europe’s bleak shores, isn’t helping our many multinational companies who earn part of their profits in Europe and have to convert them back into dollars at lower euro exchange rates. In the near term, it is difficult to discern how any of these trends will dramatically reverse. So no near-term catalyst here for equity markets under siege. Hmm....
Europe teetering … what else is new?
A potential boon to the global economy would be some sign of stability in Europe, if not a more robust recovery. We are sure this will come. We just aren’t sure when. For the moment, we have news flow out of Spain continuing to worsen, and heading we believe towards an inevitable sovereign bailout, under strict terms to be set by the Germans. But this won’t likely happen until at least September, when the German Supreme Court finally approves the European Stability Mechanism (ESM), the European bailout facility. In the meantime, the European Central Bank (ECB) will try to bridge the gap, it seems, through some form of interim funding, a la last December’s Long-Term Refinancing Operation (LTRO) facility. The ECB action keeps us confident that a complete meltdown in Europe is simply not going to happen. On the other hand, given the structure of European decision-making, and the public way in which bailouts need to be negotiated and positioned for domestic audiences, the process promises to be a continued slow grind. This will do exactly no good for the collective European economy. So more of the same here. Great....
U.S. election outcome: Too close to call
Another piece of news over the last two months has been that the U.S. election remains tight, and is likely to continue to remain tight, right up until election night. While presidential elections are always important, this one is probably historic for the stock market for three reasons. First, the vision forward is so distinct between the two sides, with President Obama promising an even further left, almost European-style future where private-sector entrepreneurs and growth drivers will be increasingly under attack, and Gov. Romney supporting a return to private-sector driven growth and American-style capitalism. Second, with control of the Senate also up for grabs, the market faces a range of outcomes on election night that includes everything from Washington gridlock to one-party rule. Third, because both the sequestration process calling for massive health care and military budget cuts, and the expiration of the Bush tax cuts, are on autopilot for a Jan. 1 implementation, the election will be the only chance the economy has to alter what looks to be a massive fall off the “fiscal cliff” in early 2013. Wonderful....
China slowdown likely to be tempered by policy action
A ray of good news soon could be an acceleration in policy action in China to reignite domestic growth there. We’ve already seen a number of monetary policy moves, and this week, we saw one of China’s many local provincial governments announce a major fiscal stimulus expenditure. This will help counter bearish arguments for a China crash landing. On the other hand, China’s economy remains an export machine, and with the big export markets of Europe in recession and the US on hold pending the election, it will be difficult for China to do much more than achieve a stable landing. This is good, but not great....
U.S. earnings machine: Stable but approaching stall speed
Despite all the gloom, which has been with us since the Lehman crisis back in 2008, a key driver for U.S. equities has been U.S. earnings, which have more than doubled off the $49.51 lows in 2008. But this driver seems to be in pause mode at the moment. With all the uncertainties and global difficulties outlined above, U.S. companies in aggregate are having difficulty growing their earnings off of their relatively high base, and this problem is more apparent when you look at revenues. Through this morning, the S&P 500 companies that have reported are showing quarter-over-quarter earnings declines of1.2%, with revenue declines at 1.8%. And the outlook for the second half, at the moment, seems no better. Theoretically, 2013 should be a much improved year, but that prediction hinges on Europe finding a path towards a tighter fiscal, banking and financing union, and the U.S. elections producing a more market-friendly administration and Congress. We’re hopeful we’ll get both, but, as I often remind myself when surveying the investment scars which riddle my body, “Hope is not a process…”
Slinking into our bull cave
With all these gloomy data points arriving on our desk over the last two weeks, we’ve focused our optimism for the future on some of the stouter legs of the bull case. Equities remain dirt cheap, bonds remain ridiculously overvalued, and policymakers remain very focused on supporting capital markets. This is all good, and we remain confident that for these reasons, along with the temporary nature of the issues outlined above, the secular bull market lives on. Still, we have a desert of sorts to cross to get to the promised land, and the hands of the policymakers who are supposed to be air-dropping water, manna, and other needed supplies as we make the trek appear somewhat restrained by politics. With this backdrop, we are recommending investors use the present rally, driven by promised ECB policy action, to lighten up on their equity overweights and put some dry powder away for a better day. It will come.