Are Markets Ready for a Correction?
By Chris Maxey, Ryan Davis
October 2, 2012
THIRD QUARTER CLOSES ON DOWN NOTE
The final week of the third quarter saw a continuation of recent volatility, as the S&P 500 Index lost 1.3% and the Dow Jones Industrial Average shed 1.0%. For the full quarter, though, equity markets were up anywhere from 4% to 6%.
A series of disappointing economic reports led to investor concern that economic growth is weakening from an already low rate. The clearest picture of this emerged in the Citigroup Economic Surprise Index, which fell sharply after a weak durable goods report.
Source: Thomson Reuters
On the economic front, economists were caught off guard by a downward revision to second quarter GDP. Following an initial estimate of 1.7% annualized GDP growth for the quarter, the Commerce Department reduced its estimate to 1.3%. Lower inventories were a contributing factor, as was reduced domestic demand.
Consumers did little to mitigate concerns that growth would continue to be weak in the third quarter. The August personal income and outlays report showed a 0.1% increase in personal incomes and a 0.5% rise in spending. After adjusting for inflation, spending was higher by only 0.1%, reflecting recent appreciation in gas prices.
Stagnant income growth was not as readily apparent in consumer sentiment figures. The University of Michigan Consumer Sentiment survey rose to 78.3 in September, with reduced optimism about the current environment offset by a rising expectations index.
Source: Haver Analytics
There was some positive news on labor markets that eased concerns about consumer psyches. A sneak peek of the annual benchmark revisions to the nonfarm payroll report showed the economy actually added 386,000 jobs more than initially counted in the 12 months to March.
Source: Wall Street Journal
Initial jobless claims also fell sharply in the week to September 22, dropping from 385,000 to 359,000. It was the lowest reading since July and could act as a modest tailwind for this week’s labor report.
Completely unexpected last week was a sharp 13.2% decline in durable orders in August. The headline has a tendency to be volatile month-to-month, but even excluding transportation, orders were off 1.3%. Aircraft orders played an outsized role in driving the headline number lower, but the underlying weakness was not encouraging. One piece of positive news is that core capital orders rose 1.1%, suggesting a modicum of strength in portions of the economy.
Also receiving attention last week was analysis from several media outlets showing that quantitative easing is less beneficial for markets than originally thought. According to The Economist, recent stimulus has boosted market valuations (price/earnings) but not corporate profits. Another recent paper from the Bank for International Settlements (BIS) found that “the benefits of accommodative monetary policy during a downturn for the subsequent recovery are more elusive when the downturn is associated with a financial crisis.”
Source: The Economist
Adding to market conservatism is the upcoming earnings season. With the third quarter officially over, Alcoa will unofficially kick off earnings season on October 9th. FedEx recently gave investors a taste of what might be to come when it revised fiscal 2013 guidance down. FedEx cited weak global growth as a primary cause of the revision. Caterpillar went one step further last week, cutting earnings expectations through 2015, while also citing a deeper than expected slowdown in economic growth.
According to FactSet, 82 companies already issued negative third quarter guidance and only 21 issued positive guidance. Since June 30, estimates of earnings per share have fallen 4.5%, which is roughly in line with previous quarters. FactSet found that what makes this environment unusual is that equity prices rallied by more than 6%, a rare feat in the face of falling estimates. There are 20 quarters where estimates and prices move opposite to one another, but only six quarters when both move by 3% in the opposite direction.
ARE MARKETS READY FOR A CORRECTION?
Entering the final quarter of 2012, many investors may find themselves apprehensive about the outlook for markets and the broader economy. While the pace of economic disappointment appears to have slowed down – and actually reversed according to the Citigroup Economic Surprise Index – actual data levels continue to suggest an anemic economic state.
With the Commerce Department’s final release of Q2 GDP on Thursday, investors were presented with the reality that the US economy remains well below its long-term trend. Meanwhile, estimates for the third quarter figure, due out on October 26, average out to a tepid 1.8%. Other measures of economic activity, including manufacturing and consumption, remain meager at best, far below the levels needed to promote a sustained recovery. In some cases, such as for the ISM manufacturing index, activity has actually retrenched into negative territory.
More concerning is the slowdown in the corporate sector. With so much negative guidance heading into third quarter earnings season, there is legitimate fear that earnings will fall into negative territory for the first time since the recovery began. While corporations remain healthy from a balance sheet perspective, the lack of top line growth may undermine one of the primary pillars of support for equity markets.
Indeed, markets have already begun to display some unease, with the S&P 500 falling some 30 points since peaking at 1472 on September 14 (one day following the latest FOMC meeting announcement). Put in a different context: the index finished the quarter by declining in eight of the final 10 trading days of the period. The magnitude of those declines has been modest, however, with the S&P 500 just 2.1% lower since that intraday high two weeks ago.
This may simply be the case of investors locking in some QE-fueled gains before the start of earnings season, but it begs the question of whether a sharper, more extended correction is in store for the near future.
Many technical indicators suggest no. Measures of breadth and momentum are consistent with a healthy bull market. As of quarter end, 74% of S&P 500 stocks were above their 200-day exponential moving average, up from the high 30’s in early June. Meanwhile, both primary and secondary indices are trading above their intermediate-term averages, suggesting internal market strength remains robust.
Speculators appear to share this market optimism. Futures contracts on US equity markets reached a net long position of $51 billion, a record high according to SentimentTrader.com. In contrast, that measure stood at a $58 billion short position one year ago. Traders in the options markets also remain generally bullish, with implied volatility among the lowest levels of the recovery. Put-to-call ratios have trended down over the past month, suggesting more investors are purchasing upside potential rather than downside protection (although some view this as a sign of complacency, and thus as a negative for equity markets).
On the other hand, smart money does not appear to be buying the market rally. In data produced by Deutsche Bank, hedged equity managers have steadily reduced their equity sensitivity as QE3 rumors fueled a rally, preparing for a sharp market downdraft. This is in contrast to previous monetary actions in which managers increased exposure. Separately, a survey of manager sentiment by the NAAIM fell to 69.75 after reaching a near-term peak of 82.89 in August. The figure represents the percentage of equity exposure active money managers retain as of the reporting period.
Source: Deutsche Bank
Credit markets are also signaling a noticeable shift in sentiment. The high yield market has exhibited its deepest declines since May, a more turbulent period for risk assets. Investment grade markets have also seen a reversal, with investment grade CDX spreads jumping 20 points since mid-September.
Source: Pragmatic Capitalism
Other troubling signs have emerged. According to Bijal Shah of ISI Group, the number of corporate insider sellers outnumbers buyers by more than six to one, a ratio rarely exceeded in recent years. Barron’s notes that while this isn’t quite a flashing red warning sign, “it has tended to precede a softer period for economic momentum and the equity tape.”
Meanwhile, equity mutual funds continue to experience significant outflows. In data released by the Investment Company Institute, outflows to global equity funds totaled $11.7 billion in September, with one week still to be recorded. This follows a $22 billion outflow in August, despite positive equity market momentum. While some of this is a manifestation of a transition from active management to ETFs among investors, a structural dearth of demand remains a headwind for the asset class to grind higher.
With the Fed seemingly nearing the end of its options in terms of monetary policy, it remains to be seen what will support risk assets going forward. Several potential negative catalysts remain on the horizon, most important of which is the fiscal cliff and prospects for a legislative solution. If no agreement appears imminent, volatility will almost certainly return to greet investors this holiday season.
The Week ahead
A busy slate of economic data is on tap for this week, headlined by the government jobs report on Friday. The Institute for Supply Management also releases its manufacturing and non-manufacturing indices, two important measures of economic activity.
On Thursday, much anticipated minutes from the early September FOMC are set for release. Traders will closely examine the transcripts in an attempt to glean any additional information as to the Fed’s thinking surrounding QE3.
The ECB and Bank of England meet this week, although no new formal change to policy is expected. Nevertheless, language in the ECB’s official statement and Q&A session will likely come under significant scrutiny. Other central banks meeting include Australia, Poland, Japan, and Russia. Poland is expected to cut rates by 25 bps.
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