There was something odd about the last earnings season: while many companies beat Q4 expectations, few were rewarded by material stock upside, yet companies which missed, or guided lower, were violently punished, falling on average in the high single-digit percent range.
According to some, this is an indication of just how priced-to-perfection corporate America has become. Others pointed out that the fact that much of Q4 earnings took place around the late January market meltup and subsequent historic Feb 5 volatility explosion didn't help, however, that is not an excuse: as Bloomberg points out, no less than 80% of S&P 500 gains have come during earnings seasons since 2013. Over that period, stocks had a perfect streak of rising whenever results were being reported; the streak ended in February.
Meanwhile, as we previewed last weekend, after the passage of Trump’s tax cuts, the expected annual gain in S&P 500 EPS stands at 18% for the Q1 period, the highest since 2011.
What is less clear, as Bloomberg again notes, is whether clearly even this hurdle will be enough "to restore order in the market." An identical improvement was under way last quarter when rising bond yields and signs of a trade war sent stocks into a correction.
“If we were to see another negative reaction to very healthy year-over-year growth, that’d definitely be a red flag,” said Charlie Smith, who helps oversee $2.5 billion as chief investment officer at Fort Pitt Capital Group in Pittsburgh. “It’s the old saying, ‘It’s not the news, it’s how the market reacts to the news that matters.”’
Last Friday, Goldman's chief equity strategist David Kostin doubled down, warning that the downside risk for misses will be substantial: "Positive 1Q surprises would confirm investors’ existing confidence in corporate fundamentals,” Kostin wrote in his latest note to clients. “However, if 1Q results disappoint, fears about decelerating economic activity will compound mounting concerns around trade, regulation, and stretched positioning.”
An ominous sign that Wall Street's euphoria is now fading fast, is that analysts are rushing to slash their forecasts for share prices just days before the start of first-quarter earnings season. Total downgrades on price targets for S&P 500 companies exceeded upgrades by almost 200 over the past week, the most since early 2016, data compiled by Sundial Capital Research and Bloomberg show.
Meanwhile, in a follow up note from Goldman's derivatives strategist John Marshall, he doubles down on Kostin's warning and writes that "the cross-currents of tax reform, wage inflation, rising rates and repatriation have driven unusually high dispersion in earnings estimates over the past 5 months. The environment is likely to get more complicated rather than less as widening credit spreads, trade war fears and Tech regulation are escalating issues over the past month. We expect this environment to favor stock pickers focused on estimate revisions with a keen awareness of positioning."
How should investors position themselves to avoid getting hurt by an adverse reaction this earnings season? These are Goldman's key observations:
- Index options: Open interest shows investors are not well-hedged ahead of earnings season and put-call skew show calls are in high demand relative to puts. At the macro level, the “buy-the-dip” sentiment continues to dominate positioning.
- Single Stock options: Put skew and put-call volume ratios show that fear at the single stock level has increased ahead of earnings. Options imply a +/- 5.6% move on earnings day for the average stock in the S&P 500; the third highest implied move in the past 8 years.
- Staples and Energy have underperformed their normal relationship with macro assets by more than 20% over the past year, setting up for a relief rally on positive estimate revisions.
- Tech underperformance over the past three weeks as mean-reversion rather than evidence of serious tail risks; we are selective and balanced in our TMT exposure on today’s list.
There are two additional points made by Marshall: the first goes back to an issue we have noted previously (and which Kevin Muir discussed on Tuesday), namely that so far, volatility increases have been isolated to Equity.
Equity volatility has remained persistently elevated over the past few weeks, but volatility has yet to rise in other asset classes. Below we show SPX implied vol indexed to two years ago, compared with the average 3-month implied volatility across 10Y interest rate options, Euro, Yen, Pound, CDX HY, Copper and Oil.
In Goldman's opinion this is bullish, as the bank "believes there is room for equity investor concerns to decline and underpins our constructive view ahead of earnings." Alternatively, it shows that vol in other assets is artificially low in a time when central banks are tightening, when inflation is rising, when LIBOR is 2.3%, when trade and all too real wars are just around the corner, and could explode higher, resulting in cross-asset contagion and slamming stocks and all other risk assets lower.
In short, there certainly are enough negative catalysts floating around.
Subjective views aside, there was another, more actionable take from Goldman, which pointed out that in a surprising twist, heavily shorted names are now showing lower than expected volatility. In fact, "for the first time in 6 years, the volatility of the S&P 500 has been greater than the volatility of the most shorted stocks."
This has significant implications for trading styles as it suggests that investors that short stocks (i.e. Hedge Funds) are not making big changes to their positions on a daily basis - something we have known for a while (see "This Is A Paralyzed Market": Hedge Fund Turnover Drops To All Time Low") - even as investors that trade at the index level - i.e. retail investors - are rapidly changing their positioning.
Two consequences emerge:
- As Marshall notes, it is increasingly important for portfolio managers to know how much of their stocks are owned by passive funds as that appears to be one of the primary sources of the recent volatility.
- In a sea-change for generations of hedge fund traders and analysts, who toiled late into the night to spread competitors' 13-F filings, Goldman says that it may now be less important than normal to track the institutional investor ownership of stocks as that is not the primary source of recent volatility.
So what is important for volatility (and thus alpha)? The answer is ETF flows, which as a reminder have become extremely, painfully fickle.
And scariest of all, if only for hedge funds, ETFs are really retail investing vehicles. So what all of the above really means is that for the "smart money" institutions to, well, make money, they have to guess what the so-called dumb "Joe Sixpack" money will do at any given moment, and certainly over Q1 earnings season which begins tomorrow, and which probably guarantees that nothing short of sheer chaos is about to break out...