Ugly earnings by Monsanto today say sector selection will count during third quarter reporting season
The really ugly earnings report delivered today by Monsanto (MON) should go a long way toward clarifying the debate over calendar third quarter earnings. The company announced a loss of 19 cents a share for its fiscal fourth quarter that ended on August 31 and said that earnings would remain weak through 2016. Analysts had expected a loss of 3 cents a share. The company also reported that it cut 2,600 jobs or about 12% of its total workforce.
What’s that you say—you didn’t know there is a debate over earnings for the calendar third quarter? Earnings per share for the stocks in the Standard & Poor’s 500 are projected by Wall Street analysts to fall by 6.9% in the quarter.
End of debate, no?
Well, no. There’s a good possibility that the projected decline in S&P 500 earnings overstates the weakness in the quarter. The index, in comparison to the actual economy, over-weights the energy sector. Which raises the possibility that overall corporate profits—outside the energy sector–are better than projections for the S&P index indicate.
That side of the debate scores some points in the Federal Reserve’s report “Nonfinancial Corporate Business Profits.” In the calendar second quarter, corporate profits by the Fed’s measure climbed 11% year over year. That’s the most since the fourth quarter of 2012. In contrast the S&P 500 showed a decline in corporate profits of 2%, according to Bloomberg.
Goldman Sachs has an explanation for the disparity. The plunge in oil prices, revenue and earnings that is hammering energy company profits is one side of the positive effects of ultra low interest rates, low energy costs, and restrained wage growth has been good for company profits everywhere outside of the energy sector. Income in the third quarter is projected by S&P to grow by 10% or more in telecommunications, technology, consumer discretionary, and health care.
The big wild card for the overall earnings picture is the strong dollar. How will that affect profits for big U.S. exporters?
From the evidence in Monsanto’s report today, companies with big exposure to the negative effects of a strong dollar, with big exposure to commodities markets, and with big exposure to emerging economies are going to show disappointingly weak earnings. Monsanto took a hit as a strong dollar damped sales across Latin America and as the company continued to cut prices (although the worst of that seems to be over.) Monsanto continued to face pressure on its Roundup product from generic glyphosate with farmers looking to save money in the face of commodity price pressures. Brazil, where the economy is in recession, added to the decline in profits.
It would be a good strategy to focus on sectors experiencing solid profit growth and stay away from laggards—but if growth at the laggards is bad enough, it can, history says, take the entire market into a downturn.
Very careful and very selective buying would seem to be in order on dips in the stronger sectors of the market.
So why does the prospect of a quarter-point interest rate increase from the Fed so unnerve financial markets?
So what’s making the U.S. and global markets so nervous?
It’s very clear that markets are worried. The Dow Jones Industrial Average put in a 444-point swing yesterday, September 9, between the high for the trading day and the low. The Standard & Poor’s 500 has closed with a move of 1.3% or more on 11 of the last 14 trading days—including the biggest rally since 2011 and the biggest down day in four years.
Among other worries there’s China. Concern about global growth. Anxiety about collapsing emerging market currencies (Brazil’s real) and economies (Brazil, Russia, South Africa, etc.)
And, of course, the will they/won’t they speculation ahead of the Federal Reserve’s September 17 meeting on interest rates. Will the Fed decide on the first increase in interest rates since 2006? Or will Janet Yellen and company put an increase off until October or December in 2015 or even into 2016?
Which should lead you to ask why a potential interest rate increase of 25 basis points—that’s one-quarter of a percentage point—should produce so much anxiety and such big market swings. It’s not like another quarter of a percentage point is going to have much effect on the real economy. Very few consumers will decide not to buy a car or a house because it will cost them another 25 basis points in interest. And very few CEOs will put off expanding a factory or hiring new workers because short-term interest rates just went from a range of 0% to 0.25% to a range of 0.25% to .50%.
The focus on the Fed decision gets even more puzzling when you consider that the debt markets have already priced in an increase. The forward contracts on the 10-year Treasury notes predict a gradual increase to 2.4% in a year from 2.22% on September 10. The current yield is up from 2.12% on January 2 and from 2.14% six months ago on March 10—but while the markets are projecting higher interest rates than now, they’re hardly projecting run-away interest rate increases. For anyone looking for a mortgage, for example, changes of this magnitude don’t make much of a difference in how much house you can afford or a buy/no buy decision.
So what’s all the tsuris?
Well, you see the Federal Reserve doesn’t have a very good record when it comes to gradual interest rate increases. As much as Janet Yellen and the governors of the Federal Reserve keep saying that interest rate increases will be very gradual because the low rate of visible inflation doesn’t require anything faster, Wall Street and indeed any investor with a memory knows that the Fed has a history of big increases in interest rates once it starts moving the yardsticks.
For example, in June 2004 the Federal Reserve began an interest rate increase with rates at 1%. It ended with short-term rates at 5.25% two years later
The worry isn’t really that increase to 0.50% in the very near term, but the possibility that the Fed, despite its current language, will embark on a long cycle of rate increases.
That possibility is lower than it was at the beginning of 2015 but it certainly hasn’t disappeared. In fact it hasn’t moderated as much as you might imagine given some of the uncertainty in global economies and financial markets.
Back at its March meeting of the Federal Reserve’s Open Market Committee members saw a range of short-term rates for 2016 at 0.25% (one vote) to 3.75% with the largest group of members at 1.5% to 2%. In 2017 the biggest grouping in the projections was a 3% to 4%.
That would be a substantial increase from the current 0% to 0.25% rate in two years, although the end rate would still not be as stiff as the 5.25% of 2006.
By the June meeting interest rate projections had moderated at bit. The highest level projected by any member for 2016 was 3% with the biggest grouping at 1.5%. For 2017 the range ran from 2% to 3.75% with six members at 2.25% to 2.75% and six at 3.5% to 3.75%.
With the historical spread between the short-term rates set by the Federal Reserve and the 10-year Treasury rate set by the market averaging about 2% home buyers would be looking at something like a 4% to 5.75% mortgage rate (since mortgage rates are benchmarked to the 10-year Treasury. At the upper end that would be significantly higher than the 4.05% interest rate on a 30-year mortgage as of September 9.
Of course, the spread between the Fed funds rate and the yield on a 10-year Treasury has been as high as 3.75% in the last decade, according to the St. Louis Federal Reserve Bank. A spread like that would push mortgage rates to 5.75% to 7.50%.
Rates that high would crush the housing market and put a big damper on the economy. And they, along with the strong dollar that goes with higher interest rates, would hit already challenged emerging market currencies.
The Federal Reserve is extremely unlikely to let interest rates get that high in the absence of inflation substantially above its 2% inflation target. Especially since the Fed’s entire policy of quantitative easing has been built on stimulating the housing market through lower mortgage rates.
Still central banks do make policy mistakes.
As we approach the September 17 Fed meeting, an aggressive cycle of interest rate hikes in 2016 is what the market fears rather than that first increase of a quarter of a percentage point.
And no matter what the Fed does in September, October or December, the U.S. central bank will find it hard to put that worry behind it. (Which is one reason to think that the Fed might move in September. A September move, followed by nothing, would convince some in the debt markets that the Fed was serious about moving slowly.)
A big week for China news hasn’t started off well. And that says, “Watch out!” when U.S. stocks resume trading on Tuesday, September 8. In recent weeks global markets have followed the lead of China’s markets—generally lower—so even if you don’t own any Chinese or emerging market equities, a week of negative data wouldn’t be a positive development for your portfolio, and especially for any commodity positions.
Today’s news showed that China’s huge foreign exchange reserves got a bit less huge in August. China’s foreign-exchange reserves fell by a record last month as the People’s Bank sold dollars to support the yuan and prevent that currency from falling even further after the central bank’s surprise devaluation. China’s reserves fell by $94 billion to $3.56 trillion at the end of the month. (Economists surveyed by Bloomberg had expected a drop to $3.58 trillion.) Clearly, China still has plenty of cash to use in supporting the yuan, but the big drop in reserves, plus the cost of direct purchases of stocks to support the Shanghai market, does increase the pressure on the People’s Bank to limit its interventions in support of the markets. (Which thought doesn’t make Chinese markets happy.)
On Tuesday, tomorrow, the government will release trade figures for August with the fear among traders being that China’s exports will come in flat again—they’ve been flat for the first seven months of 2015—and that imports, down 15% in that period, will show another decline. On Wednesday, traders will see inflation numbers, which should show prices well under control. The week’s data dump ends on Saturday with news on industrial output, retail sales, and investment—all crucial numbers for anyone trying to figure out how fast China might be growing.
An impending death cross for the Shanghai Composite index hangs over all this and colors the reaction to these numbers. A “death cross,” according to technical analysis, is when the 50-day moving average falls below the 200-day moving average. It’s not a good thing, technicians say, since it indicates continued weakness in the price of a stock or, in this case, an index. Today, September 7, the Shanghai Composite was teetering on the edge of putting in this negative sign.
That wouldn’t do anything good for market sentiment.
The selling Friday started in China as fears of a slowdown in economic growth in that country intensified worries that the global economy was headed for a serious slump.
On a big picture level, the flash manufacturing purchasing managers index from Caixin/Markit economics dropped to 47.1 in August from 47.8 in July. (Anything below 50 indicates contraction.) The drop in the sector index was the fastest decline in six years and marks the lowest level since March 2009. On an industry/sector level market research Gartner reported that quarterly sales of smartphones had dropped for the first time ever.
The immediate result was a 4.3% drop in the Shanghai Composite Index. At Friday’s close of 3507.7 the index is again deep into bear market territory with a decline of 31.5% sine the June 11 high of 5121.6.
It didn’t take long for fears of slowing growth in China to ripple out across global markets in everything for oil (U.S. benchmark West Texas Intermediate fell another 2.17% at the close to $40.45 a barrel after trading a low as $39.86 a barrel in intraday trading) to technology. Apple (AAPL) let the U.S. technology sector lower with a 6.1% retreat (pushing the stock into bear market territory with a 20% decline.) The semiconductor sector fell into a bear market too. Technology momentum stocks, such a Netflix (NFLX) plunged. Shares of Netflix dropped 7.6% on Friday. Internet security high-flyer FireEye (FEYE) retreated 8.1%.
The Dow Jones Industrial Average fell into 10% correction territory from its May high. The Standard & Poor’s 500 stock index finished lower by 5.5% for the week.
That’s all history, of course—although it is very recent history. What you want to know now is where stocks go from here.
Start with a recognition that the drop of last week (and not just Friday) has done considerable damage to the structure of global stock markets. Sectors all across the U.S. market—biotech and media, as well as semiconductors–are in correction, which always raises fears that a 10% correction will turn into a 20% bear market drop. U.S. stocks have clearly broken out of the narrow 150-point trading range that has dominated the year—to the downside—and major markets are setting major lows. The NASDAQ Composite index, for example, made a six-month low. Individual U.S. stocks have fallen below support at 50-day or even 200-day moving averages and market leaders such as Apple are in bear markets. (I’d add in the huge bear market drop in Alibaba (BABA) on the New York market with shares down 42.8% from their November 10 peak and down 26.9% from the May 22 high.) Indicators such as the CBOE VIX volatility index soared last week with the VIX climbing 46% to 28.03 (a 118% gain for the week) as lots of investors and traders bought options to protect their portfolios. If nothing else that’s an indicator that traders are looking for continued high levels of volatility in the weeks ahead of the September 17 meeting of the Federal Reserve.
Add in a bear market in emerging markets that has continued to punish the usual suspects (Brazil and Malaysia) and that continues to suck in new victims. The Turkish lira, for example, finished the week at historic lows against the U.S. dollar.
Factor in what looks like a lengthy period of confusing signals about growth. It’s likely to be quarters before growth in China rebounds or at least settles down enough so that traders and investors stop worrying that this locomotive of the global economy isn’t about to suffer a train wreck. Most forecasts for the next few quarters point to China’s growth falling to 6.8% or less, significantly below the official target of 7%. There’s nothing wrong with 6.8% growth—except that once traders see the Chinese economy breach 7%, it’s going to take a few quarters of 6.8% or 6.6% growth to convince them that 6.8% isn’t a prelude to a descent to 6.4% or 6.2% or even lower. Fortunately, there’s a good chance that the next quarter or two will produce stronger growth data in the United States. Number crunchers who look study the way that later data moves preliminary reports of GDP growth up or down say there’s a reasonable chance that the 2.3% annual growth reported so far for the second quarter will get revised upward when more complete figures and a new GDP growth rate are reported on August 27. The upward revision, some economists say, could be as high as full percentage point. Investors and traders will get their first read on third quarter GDP growth On October 29. (After the Fed decides on interest rates in September, by the way.) On August 18 the Federal Reserve Bank of Atlanta released its latest forecast for third quarter GDP growth. The Atlanta Fed forecast just 1.3% growth—which certainly seems disappointing, until you realize that this forecast is up from 0.7% in the August 13 forecast. There is the possibility that the trend is running toward higher growth and that we’re looking at better than expected growth in the third quarter. Growth of better than 3% on revised numbers for the second quarter and something above 2% for the third quarter for the U.S. is going to look pretty good in a slow growth global economy and those also going to say that there’s another growth engine available besides China. Of course, we won’t actually have the data to dispel fears and back up hopes until the end of August and the end of October.
Finally, those two dates for more GDP data neatly bracket the September decision to raise interest rates of not by the Fed. It’s hard for me to see markets settling down until after that Fed decision. Until then worries about will the Fed, won’t the Fed will be, at the least, a significant amplifier for worries about global growth.
I can’t say that global markets are going lower from here with certainty. The trends—worry about growth in China and in emerging market economies, worry about a war of competitive currency devaluations, worry about U.S. economic growth, worry about a Federal Reserve interest rate move (and worry about the possibility of a lack of a Fed move)—all seem to point lower. (And I haven’t even mentioned the continued rout in commodities.) And don’t see any immediate upside trends until we get data in the fall or later on growth in the United States and China.
The prognosis, in my opinion, is continued volatility that nets out to a drift lower for global equities including the U.S. markets until the September Fed meeting.
It’s not just the 2.1% drop in the Standard & Poor 500 today, August 20.
Or the fact that the index is now down for three straight days.
Or that the S&P 500 broke below its recent trading range.
Dig down a level and you’ll find plenty of signs that this market is profoundly nervous. That doesn’t mean we have to move into a correction but it does create a danger that something relatively minor will set off a major move to the downside.
What are the signs of anxiety that I’m seeing?
First, the severe swings in sentiment that greet relatively minor changes in fact. Yesterday, Wednesday, August 19, for example, odds of a September interest rate increase from the Federal Reserve swung from 50% down to 36% after the release of Federal Reserve minutes from the central bank’s July meeting. It isn’t just that the minutes were old news with views formed by old data that didn’t give any real new insight into the likelihood for the first rate increase since 2006. It’s also the size of the move in opinion. A move from 50% down to 36%, according to the Fed futures market is of a magnitude that shows how uncertain markets are.
Second, we’ve seen a huge decline in the ratio of puts to call options. Calls, which pay off if stock prices climb, have fallen by 36% by volume since January. Traders are spending the most on puts, which profit stocks when decline, since October 2014, when the S&P fell 9.8% and almost entered correction territory.
Third, about half of the S&P 500 stocks are trading 10% of more below their 52-week moving average. But even more significant to my mind as an indicator of market sentiment, I’m seeing selling focus on high-multiple growth stocks. For example, while the S&P 500 was down 2.1% today, Internet security high-flier FireEye (FEYE) dropped 8.4%. FireEye trades at 11.25 times revenue—the stock doesn’t have a PE since it doesn’t have any earnings.
And, fourth, what would otherwise be minor events have become big stories because they fit into themes that are at the top of market worries. Vietnam, for example, devalued the dong for the third time this year today. Big news? Only because every trader in the world is worried about an outbreak of competitive devaluations after China devalued the yuan. The devaluation of the dong could be an early sign of a current war among Asian exporters, according to this world view
As I’ve been writing lately, I think we’re going to see a lot of volatility ahead of the September Fed meeting. Buckle your seatbelts.