I’m Gonna Tell You How It’s Gonna Be…
- Joshua M Brown
- July 24th, 2011
The S&P 500, at 1345, is within 20 points of its weekly closing high from April 25th (1363).
Here’s what I’m thinking is about to go down: A chilling head-fake sell-off followed by new highs for equities.
After this era of market action ends, they’re going to need to start bringing English Lit professors to the business schools to teach the students irony.
And because, in this particular cafeteria, Sloppy Irony Sandwiches are on the menu five days a week, we may as well accept how they taste at this point.
With that in mind, I’m going to lay out the most ironic outcome that you could possibly imagine for the coming two- to three-week stretch. It is not so much a forecast as it is a gut feeling with some educated inferences and a whole lotta real experience to back them up. I am not betting aggressively on the below scenario but I think there is some educational value to be found in the way I’m laying it out…
No more preamble, if we’re going to make an omelet we’d better start cracking some eggs:
1. The first thing you need to understand about the stock market is that it’s been designed to frustrate the maximum amount of people at any given time. You’ll no doubt remember the clarion calls to overweight commodities and emerging markets this past winter – both asset classes are negative year-to-date while US stocks are on pace for annualized gain of 12% – how’s that for a “how you doing?”
2. Stocks have been caught within a fairly narrow 7%-ish trading range since the beginning of the 2nd quarter as analysts spent 10 straight weeks cutting earnings estimates for the S&P 1500. This despite the fact that the S&P 500 exhibited a 60% earnings beat rate in the first quarter and a whopping 67% beat rate on revenue expectations. This recent analyst doubt coupled with persistently negative employment reports and the monotonous sound of GDP estimates being cut put a ceiling above the indices for going on six months now.
3. But a funny thing happens when Wall Street makes a concerted effort to curb their own enthusiasm – stocks become blessed with the gift of low hurdles to hop over. As of Friday, we’ve heard from 143 S&P 500 companies and an incredible 75% of them have beaten analysts’ estimates! In other words, our current “beat rate” is an order of magnitude above the one from Q1 – even as the economy itself had slowed during the quarter we’re hearing about. Irony has been hitting the weights and working out with Roger Clemens’s “trainer”.
4. In the absence of the debt ceiling drama and the European sovereign debt nightmare, it is my opinion that the market would’ve already broken out to new highs based solely on earnings growth, a new crop of leadership stocks and the p/e multiple expansion that inevitably comes after periods of both compression and a ludicrously-loose Federal Reserve. Investor sentiment, while on the rise, has not yet attained the April levels when we were hearing about the economy’s having hit “escape velocity”. But with stocks having rebounded nicely from their June 24th correction lows, some frowns have begun to turn upside-down, you can expect more of that as earnings continue to “surprise and delight”.
5. In addition, stocks should also be benefiting more from the cartoonishly-poor opportunities in today’s bond market. Many of the most tenured and demonstrably successful asset allocators of the current era are favoring the low-multiple, high-dividend payers with which this equity market is littered. With 20% of the S&P 500 yielding more than the ten-year treasury (according to Bespoke as of July 18th), we are quite literally festooned with opportunities for non-bond income.
6. Lest there be any doubt about whether investors can continue to enjoy the strong corporate picture against the backdrop of a shaky sovereign one, I call your attention to a recent JPMorgan report on CDS pricing and default risk: “As of yesterday, 22% of US high-grade issuers (from the J.P. Morgan JULI index of 250 issuers) have a CDS spread inside that of the US government. This is up from zero a year ago.” Meaning, institutions buying and selling insurance against potential default believe that Coca-Cola and its ilk have bonds that are a less risky credit than the stuff coming from the US Treasury. JPMorgan is saying that “corporates are the new sovereigns,” and the market is demonstrating its acceptance of this each day. What this means is that “haircuts” and “selective defaults” are more likely to be greeted with a “we know” than a “holy sh*t” reaction going forward.
7. Let’s turn to our own little sovereign debt deadline, the August 2nd debt ceiling ultimatum. Obama’s going to lose, but he’ll lose gradually. The GOP has challenged the President to a staring contest and when a crazy person stares down a weakling, guess who ends up blinking first? Most of the restructurings and adjustments and budgetary voodoo will take place over an extended stretch, they’ll come out with something temporary to allow everyone to breathe until an actual vote takes place months from now. Absent a miraculous breakthrough between the two sides, I think they’ll find 500 billion bucks to use in the meantime without anyone having to declare defeat this summer. Like the Europeans, we will enjoy a rolling “crisis” which will supply just enough sporadic headlines to keep the newspapers in business for another year. Joy and Pain on an endless loop, euphoric highs and dismal lows that everyone becomes completely enured to.
8. But as we get closer to that deadline, stock markets are going to freak out a bit. I think we get a sell-off as large chunks of money race each other to the sidelines ahead of that date and things seem less and less workable based on the thrice-daily press conferences in DC. But then when the deadline passes and the world doesn’t expire, we’ll simply skate back into the street, set up the goal, slap sticks on the ground and drop the puck. Game on.
9. There will have been enough cash temporarily-sidelined to fuel the mother of all relief rallies. The fact that there is now both a Grecian bailout in place as of this week along with a template for future ones will surely help. Even the strategist Felix Zulauf, who remains long-term bearish on the Euro situation, acknowledges that the relief from this bailout should be enough for the meltup. Here’s Alan Abelson paraphrasing Zulauf in this weekend’s Barron’s: “Thanks to the decision to once more bail out Greece, equity markets, he concludes, may rally and U.S. shares might even reach new highs in the next two to four weeks.”
10. So here’s my roadmap: We will hear from 180 S&P 500 companies this week, from Ford ($F) to ExxonMobil ($XOM) to Merck ($MRK). Some of the more troublesome reports are already behind us – thanks Bank of America ($BAC) – the industrials and energy companies coming up should all be solid. In the absence of Euro problems (for a brief moment, we hope) the focus should be on three things – US earnings reports, debt ceiling negotiations and the first official estimate of second quarter GDP which is announced on Friday. The latter two are almost guaranteed to put pressure on the markets while the strong profit reports should keep that jittery sell-off from becoming a wipeout. That briefly-panicked move lower will fail, and from this failed move will come the fast move of stocks tearing through the overhead resistance they’ve toiled beneath these past six months.
All the ingredients are present for a run to new highs as we pass that August 2nd deadline with our limbs still attached and the airplanes not having dropped out of the skies. What happens from there is anyone’s guess of course.
Years from now, when economic and stock market historians try to understand how a near-miss in Treasury coupons could fuel a rally in US stocks, you can pull up this post and forward it to them.
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The Reformed Broker is a blog about financial markets and the economy. Joshua Brown is a New York City-based investment advisor for high net worth individuals, charitable foundations, retirement plans and corporations... More.