Ready to Shift Gears with Four on the Floor
The stock market is constantly shifting gears for reasons that are not always clear. With that in mind, we thought we'd take a look at four items in the coming week -- four on the floor if you will -- that will cause the market's RPM to move in such a way that a gear shift either higher or lower could be necessary.
Earnings
The second quarter GDP report
The FOMC Meeting; and
The July Employment ReportEarnings
The second quarter earnings reports have been better than expected. That really isn't a surprise, however. More than 60% of the companies reporting their earnings exceed analysts' expectations just about every quarter. That is true again this quarter. According to Thomson Reuters, 67% of the companies that have reported so far have beaten consensus earnings estimates. That is slightly above the long-term average of 63%.
Second quarter earnings are on track to grow 4.2% versus an estimated growth rate close to 1.0% when the reporting period began. The early takeaways are as follow:
The financial sector has killed it so far, reporting growth of 27% to lead all sectors
According to FactSet, S&P 500 earnings would be down 2.9% if the financial sector was excluded
Aerospace and defense companies have shown that they have managed through the early effects of the sequester just fine
With an estimated revenue growth rate overall of 1.6%, according to Thomson Reuters, it is clear that end demand is soft and that EPS surprises have been engineered in many cases through cost-cutting, items below the operating line, and share buybacks
Multinational companies are increasingly identifying currency, the slowdown in China, and continued difficulties in Europe as headwinds
Guidance for the third quarter fits the mold once again of being predominately negative. According to FactSet, 43 of 54 companies issuing third quarter guidance, have issued negative EPS guidanceThe rush of the earnings reporting season began on July 12 when JPMorgan Chase (JPM) and Wells Fargo (WFC) reported their results, setting an upbeat tone for the financials that resonated throughout the sector. The market, nonetheless, has driven in a low gear during the earnings rush hour. Since the aforementioned reports, the S&P 500 has increased 1.0%.
It would be remiss not to add that the S&P 500 surged 7.4% from its low on June 24 to 1675.02 on July 11, so this could be a case of the market simply cooling its engine after an open-road run. Still, if the Fed takes its foot off the gas pedal, earnings growth is going to need to be of higher quality to keep the market from stalling and eventually breaking down.
In the week ahead, 131 S&P 500 companies are expected to report their June quarter results.
Second Quarter GDP
There will be a lot of media attention on the second quarter GDP report for a couple of reasons. First, it is expected to show that real GDP grew at an anemic rate in the second quarter. Secondly, the Bureau of Economic Analysis will make comprehensive revisions with this report going back to 1929 and will incorporate a new methodology for tabulating GDP (more on that in just a bit).
First quarter GDP grew at an annualized rate of 1.8% while real final sales, which exclude the change in inventories, rose just 1.2%.
Economists' expectations for second quarter GDP growth range primarily between 0.5% and 1.5%. Briefing.com is an outlier with a second quarter GDP forecast of -0.7%. Our forecast is predicated on an expectation that inventories, trade, and government spending will be notable drags on growth along with non-residential investment, which should produce a slight drag. We expect real final sales to be up just 0.1%.
The market's response to the GDP report could very well be one of a deer-in-the-headlights response, simply because participants and economists won't know what's coming at them. If there is to be an outsized response, it is likely to hinge on the extremes of a better-than-feared or worse-than-feared indication.
Anything within the popular range of expectations is likely to keep the market from shifting gears since: (a) it won't be a surprise (b) it will be written off as a dated report that is expected to give way to stronger growth in Q3 and (c) it won't change the market's perspective that a Fed tapering will wait until September at the earliest.
All that aside, a sub-2.0% number this far into the Fed's extraordinary easing process is akin to that unseemly scratching noise when shifting gears, for it will serve as evidence that the Fed's policy transmission mechanism isn't working as effectively for the real economy as advertised.
In tabulating GDP, the biggest change in methodology will come in capitalizing research and development as an investment instead of an expense. Other changes will include capitalizing long-lived artwork (eg. movies, books, and TV shows) as an investment, changing the estimates of pension income and pension wealth to account for actuarial liabilities, and accounting for more costs of buying a house, such as stamp duty and attorney fees, as investments instead of spending.
According to the BEA's analysis, the new methodology will increase the overall size of US GDP by roughly 3% but have very little effect on the growth rates. In describing the implications of the new methodology, Credit Suisse economist, Neal Soss, provided the insightful analogy that it is like measuring something in meters instead of yards. That is, the only difference is the unit of measurement.
FOMC Meeting
F-O-M-C
No four letters have had more impact on the stock market than those four letters. They have caused the stock market to shift gears a lot, mostly into a higher gear, but occasionally they have thrown the market into reverse.
The latest meeting is another two-day affair that will culminate with the issuance of a policy directive on July 31 at 2:00 p.m. ET or, coincidentally, soon after the release of the second quarter GDP report.
There was plenty of drama surrounding the last FOMC meeting on June 18-19 due to Fed Chairman Bernanke's confusing presentation when trying to communicate the FOMC's thought process on an eventual tapering. As everyone knows by now, that misunderstanding was quickly smoothed over and the S&P 500 subsequently shifted into high gear with the acumen of a Formula One racer and sped to a new, all-time nominal high.
The Fed isn't going to want to create any new, hawkish-sounding drama so soon after the last one or on the heels of Fed Chairman Bernanke's well-scripted testimony on monetary policy before the House Financial Services and Senate Banking Committees.
If the Fed does anything new, it is more apt to throw the market a carrot than a stick with its policy directive. A more definitive statement addressing the Fed's concern about inflation being well short of its target rate could do the trick in that respect. Such an admission, we suspect, would keep St. Louis Fed President Bullard from casting a dissenting vote.
Kansas City Fed President George, on the other hand, seems certain to cast another dissenting vote on concern that the Fed's policy increases the risks of future financial and economic imbalances and, over time, could cause an increase in long-term inflation expectations.
July Employment Report
With the trend in initial claims, there is a reasonable basis to think that nonfarm payrolls increased in July somewhere in the neighborhood of 175,000-200,000. The Briefing.com consensus estimate is pegged at 175,000. The average monthly gain over the last 12 months is 182,000.
Obviously, the stock market has done just fine over the last 12 months even though payroll growth hasn't been running at a pace consistent with a fast-growing economy. Ironically, that's been interpreted as a good thing, because the growth has been seen as good enough to keep the economy growing, but not strong enough to convince the Fed to start dialing back on its asset purchases.
The June report, which showed 195,000 were added to nonfarm payrolls, was seen as a step in the tapering direction. We did not view the June report as a catalyst for tapering, however, due to several reasons.
The number of employees working part-time for economic reasons increased by 322,000
The number of discouraged workers was up 206,000 from a year earlier (discouraged workers are currently not looking for work because they believe no jobs are available for them)
The number of long-term unemployed (those out of work for 27 weeks or longer) accounted for 36.7% of the unemployed, down from 41.7% a year-ago but still far too high
The U6 unemployment rate, which also accounts for marginally attached workers and underemployed workers, jumped to 14.3% from 13.8% in MayAlthough the June employment report revealed strong growth in aggregate earnings, that did not translate into strong spending, as seen in the June Retail Sales report.
On the day of the June employment report, the S&P 500 increased 1.0%, yet the 10-year Treasury note took it on the chin, rising 21 basis points to 2.72%. Since stocks did well that day in the face of rising long-term rates, the disparate move was seen as a positive sign that the stock market was adjusting to the idea that rising interest rates were a reflection of a strengthening economy and not a loss of faith in the Fed.
In other words, a tapering of the Fed's asset purchases wouldn't be good for the Treasury market, but it would be okay for stocks since a stronger economy meant good things for corporate profits.
The curious thing is that Fed Chairman Bernanke said a short time after the employment report that it wasn't as strong as it appeared. Upon hearing that, the fear of an imminent tapering (i.e., in July) was dialed back and Treasuries started to lick their wounds. The stock market, though, didn't give back its gains even though the Fed chairman negated its post-employment report optimism about the headline strength in nonfarm payrolls.
The stock market's continuing strength was essentially an indication that it continues to relish the thought of the Fed staying its policy course.
In this light then, the stock market may not shift gears as much on the headline for nonfarm payrolls as it will on other employment indicators such as part-time-workers, the long-term unemployed, or the U6 unemployment rate since the Fed chairman made it clear that he is looking at things beyond the nonfarm payrolls number when assessing the road ahead for monetary policy.
What It All Means
The S&P 500 has struggled to speed past the 1700 level. The week ahead, with all of its important items, will determine if the stock market can shift into yet a higher gear to clear that level convincingly or if it is forced to downshift to avoid some road kill that was hit with disappointing developments.
Having four on the floor requires more work when driving a car, particularly in traffic; and for the stock market, there is going to be a lot of traffic in the coming week.
The four items discussed above should leave market participants with one hand on the wheel and the other ready to shift gears, because traffic conditions are going to demand their full attention.
Source: briefing.com
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