With S&P futures, and most notably financials, staging the second overnight opening surge in a row, we thought it perhaps worth reflecting on five quite concerning fundamental reasons why dip-buyers (as anesthetized as they have become thanks to central bank 'protection') could face a tougher time. As Mike Wilson of Morgan Stanley notes, for those looking for a cause or explanation of recent weakness, feel free to blame it on the more hawkish Fed minutes, Draghi’s comments that it was now “up to governments to do the right thing” or the soft US payroll numbers. After such an uninterrupted run, some kind of correction was inevitable and simply a matter of timing. The bigger question to resolve is whether this pull back will look like what we experienced in 2010 and 2011 or end up being more muted. Obviously, the key variables for this analysis remain growth and liquidity expectations. The 'payback' that we have been warned about for such an unseasonably warm winter is upon us (as macro data surprises increasingly to the downside) and that is the first flaw in BTFD logic. Wilson goes on to point out that NFIB small business hiring intentions have dropped precipitously, GDP growth is weak but earnings growth is now catching up (down) to that weakness and for many stocks is rapidly falling towards zero, we remain in a 'liquidity lull' as central banks stand on the sidelines and reflect, and perhaps most worrisome is the rapid deterioration in the Bloomberg financial conditions index. All-in-all, these sum up to suggest a greater-than-5% correction is more than likely.
Payback Time
Risk markets have been wobbling for over a month and showing signs of exhaustion since early/mid February. However, it took a more definitive decline in the broader market averages to get most investors’ attention. Specifically, the first week of April leading into the Passover/Easter holiday weekend was uncharacteristically weak for most risk assets, even US equities. For those looking for a cause or explanation, feel free to blame it on the more hawkish Fed minutes, Draghi’s comments that it was now “up to governments to do the right thing” or the soft US payroll numbers.
After such an uninterrupted run, some kind of correction was inevitable and simply a matter of timing. The bigger question to resolve is whether this pull back will look like what we experienced in 2010 and 2011 or end up being more muted. Obviously, the key variables for this analysis remain growth and liquidity expectations. Hence, the negative reaction to last week’s central bank comments and jobs data. On the growth front, it seems pretty clear to me that expectations got ahead of reality and are now set to disappoint. Nowhere is this more apparent than with the Citi economic surprise index. This index rolled over several weeks ago and it now quickly approaching the zero line. The reality is that the jobs number was just the punctuation on a long list of disappointing economic data points this year. Markets were simply ignoring them on the expectation for employment data to trump the negatives. Whoops. Not only did the Non Farm payroll number come in well below expectations, but the NFIB small business hiring intentions survey for March fell back below the lows of the 2001-02 recession (Exhibit 1). Vincent Reinhart and David Greenlaw have been warning us to expect some payback from the unseasonably mild winter. Apparently, payback time is here.
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But stocks really care about earnings, rather than GDP, growth and while this recovery has been short on GDP; it has delivered on earnings growth in spades. At least until now. As I have noted before, earnings growth has been decelerating rapidly the past several quarters. The market hasn't really noticed or cared so much because we were falling from such a high level. However, we are now at that moment when growth is actually falling towards zero and for many stocks will be negative on a y/y basis.
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Exhibit 2 shows what this trajectory looks like with 1Q implied by what consensus is currently estimating. As you can see, we are getting perilously close to the zero line for earnings growth in 1Q. History suggests the market is not kind to stocks if we cross over into negative territory. As regular readers know, this is something I have been expecting to occur during 2012….i.e. an earnings recession in the absence of an economic one. I believe this is why many stocks have sold off in response to beating 1Q earnings estimates (ORCL, FDX, NKE,MSM and DRI to name a few). The market appears to be selling the good news much like it bought the bad news in January. As for liquidity, this is a harder metric to gage and measure. Clearly, central bankers around the world have provided ample liquidity over the past few years to keep animal spirits more lofted than they otherwise would be. I see no reason for that to change.
However, there does seem to be a change at the margin with respect to when the next infusion may come. Our cross asset research team calls this a liquidity “lull” which may be enough to cause a more significant decline in equity prices than most thought possible just a few weeks ago. Exhibit 3 shows how the financial conditions have definitely rolled over with risk assets. Some of this is auto-correlation, but it is hard to ignore the observation that we did get a negative divergence between stocks (SPX) and the “financial conditions” index on this most recent new high.
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In addition, I would also point out that financial conditions are not as loose as they were last year when stocks were at similar levels. Bottom line, slowing / disappointing economic data, zero percent earnings growth and a liquidity lull sounds like a recipe for more than a 5% correction.