David Rosenberg: "What Is Wrong With This Market?

From David Rosenberg of Gluskin Sheff

My Evolving Macro And Market Thots

What is wrong with this market? The S&P 500, instead of grinding higher in the aftermath of QE3 actually hit its peak for the year the day after the policy announcement. Go figure. Maybe economic reality finally caught up with Mr. Market (there is a very fine line between "'resiliency" and "denial" — and keep in mind that the S&P 500 is still up 14% in a year in which profits are now contracting, not just slowing down).

And the cyclicals and Financials have lagged the defensive sectors.

I looked at all the prior major non-conventional easing measures in the past four years: QE1, QE2, Operation Twist, and the ECB-led Long-term Refinancing Operation which a year ago was a really big deal in unleashing a massive global risk-on trade.

On average, six weeks hence, the S&P 500 was up more than 9% after the policy announcement. It was all so novel! Tech on average was up over 11%, industrials were up 12%... ditto for Consumer Discretionary and Materials. The cyclicals flew off the shelves.
But this time around. either Mr. Market is jaded or the laws of diminishing returns are setting in.

Six weeks after the unveiling of QE3, the market is down 2%. This hasn't happened before. Every economic-sensitive sector is in the red, and even Financials — the one sector that should benefit from all the "sucking at the Fed teat" — have made no money for anybody! Of course, there are the compressed net interest margins to consider.

The bottom line is that since that famous September 13th FOMC meeting that had the bulls going hog wild, the only equity sectors that are in the plus column are ...

  • Utilities: +1.5%
  • Health Care: +2.4%
  • And while Consumer Staples are down fractionally, they have outperformed the broad market by 120 basis points

In other words, as aggressive as the Fed has become, maybe, just maybe, Mr Market is starting to focus on the patient rather than the prescription.

The problem is that at the highs, the market had become overbought and right after that September 13th QE3 announcement, the CFTC (Commodity Futures Trading Commission) data showed the hedge funds had already jumped in and the buying power became quickly exhausted. Sentiment surveys and the low levels of the VIX index flashed a certain level of complacency. On each of these post-QE rallies, momentum had become increasingly diminished, and it has been no different this time around. And the bond market has consistently refused to buy into the economic reacceleration viewpoint dominated by the equity bulls. A cursory look at the charts suggests that a near-term top has been turned in and the popular view of a rally into year-end is beginning to look a bit discredited here.

S&P 500 revenues are set to decline on a YoY basis for the first time in over three years. Here we are, one-fifth into earnings season, and less than 40% have managed to beat their sales estimates - we have not seen a number this low since the first quarter of 2009 when U.S. GDP contracted at an epic 5.3% annual rate (and 20 percentage points below the historical average)! I guess this does matter for the stock market, after all, despite all the money printing out of the Fed which merely debases wealth instead of creating it. With margins coming off cycle highs and all the fat already being cut out of the corporate cost structure, faltering sales can be expected to exert an outsized influence over profits in coming quarters. Be prepared for more downward revisions in the EPS outlook, which means be diversified, defensive and dividend-driven.

Of note for pro-cyclical enthusiasts, the Asian stock market, a pro-growth bellwether, has now turned in three losing sessions in a row - a 0.4% drop today with two declines for every advancer. The economic-sensitive Korean Kospi index led the decline with a 0.8% setback and China was down 0.9% in its worst day in four weeks. Equity markets are down through most of the planet today (Japan an exception) with economic and political concerns re-ignited in Europe, a spotty earnings cycle and, of course, what the polls may show with President Obama "winning on points" according to the experts with regards to last nights debate. Though it was interesting to see the incumbent sound more like a challenger... "Attacking me is not an agenda" I thought was one of the better lines of the night; I realize that people need sound-bites and the President, in classic Chicago-style-politics sarcastic for sure delivered some zingers, but Romney was most effective, I thought, and stayed on message, as non-sound-bitey as it may have been, that, sorry, Bin Laden may indeed be dead but Al Qaeda is not and is staging a comeback...  see the op-ed on this file by Jack Keane, former Vice Chief of Staff of the U.S. Army, on page A17 of the WSJ.

To be sure, Obama is a brilliant debater and ostensibly king of the one-liner, but Romney did come off as a credible leader and keep in mind that no matter the "spin", the president had a 10-point lead in the polls as recently as July and all signs still suggest a neck-and-neck race. As an aside, it's not just tax policy, energy policy and foreign policy that are at stake in the coming election, but Fed policy will likely be affected as well — for more on this file, see On Fed's Horizon; Nov. 6 Looks Large on page B1 of the NYT.

The euro is softening now on the news that Moody's cut the credit ratings of five Spanish regions and French business confidence tumbled to its lowest level in over three years in October (lnsee index down to 85 from 90, the lowest reading since August 2009). As if to add insult to injury, Spanish GDP contracted 0.4% in Q3, matching the Q2 decline (though better than what was generally expected) and the fifth straight shrinkage.

On a day when there was little in the way of data-flow, what was key yesterday was what Caterpillar had to say about the global economic outlook and the picture painted was no Picasso — announcing that the global headwinds are even more acute than previously thought, citing that end-user demand "is not growing as fast as we were expecting it would" (full-year sales seen now at $66 billion from $67.64 billion and 2013 revenues now seen -5% instead of +5%). Texas Instruments reported that its quarterly revenue dropped 2.3% as demand for its chips receded and the CFO (Kevin March) stated "across the board, we're seeing customers being extremely cautious, very careful about the level of inventory that they hold so giving us very low levels of visibility as to what they'll want to order for the quarter". Now does that sound like escape-velocity to you? Freeport-McMoRan missed its EPS target for the first time in 17 quarters ... an inflection point, perhaps? Dupont missed too this morning (cutting jobs as well) and what was that Philips Electronics said yesterday? That "the economy in the U.S. is at the moment moving a little bit sideways". Yikes... that means stagnation. No growth. Microsoft doesn't get the attention it once had with the likes of Apple and Google now the darlings of the tech world, but the bellwether is now down 10% in the past month (stock price, that is) and as such is in official correction terrain. And didn't we near from Canadian National Railway (CNR) yesterday say that it is expecting a "challenging end to the year' even though it delivered a Q3 results that fractionally beat estimates?

But at least Yahoo surprised to the high side — a rarity so far in the fairly bleak earnings reporting season (something like 8% of the S&P 500 companies report today). May as well find those needles in the haystack.

Also have a glimpse at the article on page B1 of today's NYT titled Dwindling Demand: China's Slowing Economy Puts Pressure on American Exporters. Fiscal cliff notwithstanding, the really big risk is a negative export shock about to hit the U.S. economy...  did anyone notice that Q3 industrial production actually contracted, albeit fractionally, for the first time since the depths of the Great Recession over three years ago? And if you have become a bull over Europe, notwithstanding all the ECB support in the world, the problem of massive excessive indebtedness has not gone away instead, it has gotten worse. See Despite Push for Austerity, European Debt Has Soared on page 138 of the NYT.

If deflation was not a primary theme, then we likely would not have seen gold break below its 50-day moving average this morning, with the overall commodity complex moving in the same direction (the oil price has declined now for four days running). Copper and gold (the red and yellow metals) have now traded down to six-week lows! Ditto for platinum. Now that is deflationary — and confirmed by the behaviour in the bond market U.S. Treasuries (and German Bunds) are back in rally-mode, even in the face of this week's $99 billion new- issue calendar in the government bond market and it is nice to see how the 200-day moving average on the 10-year 1-note proved to be solid support for the fifth time this year!

Again, all these market moves are diametrically opposed to what we had experienced after the prior QE moves ... call it life at the zero-bound. The only difference is that this time around, the market realizes that the Fed is pushing on a string. Perhaps in a classic sign of "unintended consequences", the Fed's actions are now doing more to hurt the Financials than help them — see Low Rates Pummel Banks on the front page of today's WSJ. Financial industry profit levels are sagging to their lowest level in three years on the back of increasingly squeezed Fed-induced net interest margins. Indeed, margins are down now for five quarters in a row and at 31.2% to their tightest levels since the second quarter of 2009 (when they needed a government bailout).

Yes, yes, housing and autos have both enjoyed good years, but don't confuse a cyclical upturn with a level shift — and I sense we are in the latter in each sector. Single-family starts now exceed sales by more than 60% and only 30% of the sales are by first-time buyers. That does not tell me housing is in some durable uptrend, and the reality is that after over-cutting, the builders have now caught up with demand. And after two years in which uber frugality took the stock of U.S. motor vehicles down for two years in a row, there was indeed some good pent-up demand (the fact that the median age of the existing stock is over 11 years is immaterial because cars are being built to last longer today) but the buying intentions surveys suggest that the peak has been turned in. The question is that if I am correct in the assertion that the mini housing and auto cycle has run its course, and all this could produce was economic growth of 1.5% for this year, then what picks up the mantle and prompts anything better than that meagre GDP trend (which is one-third what is typical for an economy supposedly heading into year-four of an expansion). Indeed, you know that the housing rebound is on a short leash when people aren't shopping for furniture or home appliances any longer—just have a look at Appliances Hit Slow Cycle on page 35 of today's WSJ.