To answer this question, it would help to recap how this meltdown
unfolded and then we can make a good estimation of what it means
for the next 2-3 months.
I will describe a shift in posture on the economy
and the market that I experienced between Friday and Tuesday -- and
that I think also happened for large institutional investors (the
ones who helped the meltdown happen).
I have been very bullish on stocks for two years.
But since May, I have been in the "sideways to lower" camp on the
broad market as we evaluated lots of "slowdown" data in a
seasonally weak period for equities. That necessitated smart
stock-picking with a focus on strong earnings as essential to
investment survival.
And I started to grow more cautious after hearing
Federal Reserve Chairman Bernanke speak in June. He has access to
more and better data about the economy than anyone. He also has a
small army (a few dozen anyway) of economists and researchers led
by David Stockton helping compile and analyze that data.
When Bernanke sounded more cautious in his June
statement and press conference, I wrote "Bernanke Worried = Rotate
Defensive."
A week later I summed up my cautious thoughts in
"Summer Pullback Over? Not So Fast."
Then came the abysmal June jobs report on July 8,
for which I wrote "Slowdown Looks Entrenched."
But I was still bullish on stocks because of strong
demand from Emerging Markets and the strong trends in US corporate
profits that derived over 40% of their earnings from it. The debt
worries in Europe and US were contained it seemed and the market
continued to shake them off.
GDP vs. Corporate Profits
Then came last week's awful GDP revisions,
resulting in first half growth of only 0.8%. When combined with
weakening manufacturing and consumer spending/income data for the
past two months, I immediately adjusted my recession probability
over the weekend from 15% to 45%.
On Tuesday when the S&P touched the March lows,
I said that technically the market was broken and we were going
lower.
On Wednesday, I wrote "Look Out Below!" and
described why the next target was 1,200. Here's what I wrote the
day before the 4.8% drop in the S&P from 1,260 to 1,200...
"Let me reiterate the bearish fundamental case
against stocks that I have been writing about since we got the
awful GDP data last Friday...
Major Premise: US corporate earnings are
strong because of strong Emerging Markets demand, not domestic
growth and consumption.
Minor Premise: First half GDP, June and July
manufacturing data, and this week's eroding ISM outlook are
trending back toward recession territory.
Conclusion: If Emerging Market economies
(China, Brazil, India, etc.) slow down fast, earnings will fall as
domestic demand will not sustain them.
The next logical conclusion is that stocks will
fall in advance of this possibility because portfolio managers
are looking at the next 2-3 quarters of earnings to justify their
investment picks, and the growth just won't be there in their
projections.The market will price in a dark year ahead for the
economy and stocks in the next few months."
Here's Why the Meltdown Happened
Once equity portfolio managers, and institutional
investors in aggregate, absorbed the huge disconnect between GDP
and corporate profits, they suddenly had to change their outlook
for equities.
Why? Because they had to figure that if domestic
demand was that weak -- which the labor market had been trying to
tell us all along -- and if there was any slowdown in Emerging
Markets, earnings were sure to fall from their record pace and
trajectory.
This meant forecasts for growth and earnings were
going to be adjusted lower for the next two quarters at least. And
when in this period of doubt, you lighten your load and get some
cash.
Portfolio managers look forward. And they use
estimates about growth and earnings to model their risk/reward.
Without domestic demand and a consumer taking it on his chin in the
labor market, they had to reason that earnings and thus market
levels were unsustainable.
And this was especially true with a red-hot Chinese
economy trying to cool its overheating engines of global growth.
All optimistic earnings projections for next year had to be
scrapped.
The earnings estimate revisions (EER) -- our
bread and butter research at Zacks -- have yet to be moved downward
to reflect this new outlook. But they are coming and we will likely
hear them in droves after Labor Day.
Are the downward EER all priced in? It's hard to
say. September will continue to as interesting as August and this
will form the logic of my forecast until November.
Self-Reinforcing Feedback Loop
A single-day 5% market drop has its own hyperactive
mix of panic, margin calls, and self-fulfilling prophecy,
especially after a week of selling that just needed a big one-day
push to be called "a correction" (down 10%).
And macroeconomic dynamics also act in feedback
loops with jobs and growth and stocks all impacting each other --
especially where confidence is the most crucial of currencies.
So while I thought the S&P was headed to 1,200
as the big boys of markets priced in a higher chance of recession,
I didn't think it would happen the next day -- and all at once!
Now that this sort of damage is done, we are in a
waiting game. What are we waiting for? Visibility on earnings,
growth, jobs, and potential government stimulus.
This isn't 2008 all over again (though it may have
felt that way on Thursday). But it does change the investment
landscape for the next few months.
My bet is that the bull market resumes in the
fourth quarter. Let's quickly look at the things we are waiting for
and get an idea of how to play the game.
QE Next and Next FED Forecasts
As I've been writing about for months, "QE Next" is
irrelevant. I mean if QE2 was pushing on a string, what traction do
we possibly gain with more extraordinary monetary stimulus?
The good news is that we know interest rates will
remain accommodative for an even longer extended period. After the
Fed meeting August 9, I am looking forward to the Fed's economic
forecasts.
These will guide policy in Washington, hopefully.
Yes, it seems that any fiscal stimulus is off-the-table after the
debt drama, which will only serve to feed election issues for the
next 15 months.
But the tax and spend debates may get shelved for a
time this fall in favor of the jobs debate. We had some encouraging
jobs data Friday morning, yet it's still not where we need to be
and once Congress gets more education about where the economy is
headed, they should align for some kind of fiscal stimulus.
Remember, we still don't have the number one
creator of jobs in a recovery humming yet: construction and
housing. And with our manufacturing jobs drifting overseas, there
are more structural impediments to growth than cyclical ones.
What Has to Happen to Prevent Another
2008
And actually, the big central banks of the world --
primarily the Fed and ECB -- may be busy watching a bigger problem.
If markets continue to melt down, they could have another liquidity
and solvency crisis on their hands. In fact, they are probably
already worried about it.
Why? Because financial markets are still a little
fragile from the last crisis and even just a sneeze that sounds
like a potential case of the credit flu could cause further
contagion and contamination fears that spiral.
We will likely hear lots of perma-bears coming out
to tell us how unsustainable the fiat currency system is and why we
should only buy gold. In any case, the Fed and ECB will be ready
with extraordinary liquidity measures to prevent any possible
Lehman disasters.
Confidence and the Consumer
In my bullish note last month, The Seven C's of
Recovery Optimism, I listed these as the number 6 and 7 driving
forces. Time for an update as both are now sorely tarnished.
Confidence: Corporations have always been somewhat
cautious as they hoard their cash; now investors are. Restoring
confidence to markets is key. The weak ISM data was an early
warning that CEOs might be looking at the economy as Bernanke did
in June and saying "Let's not buy that right now."
Consumer: Debt drama did damage; now the
"jobs-stocks-growth" feedback loop is weighing on psychology and
sentiment. When people you know are still looking for full-time
work after a year of unemployment, it sort of affects your spending
plans.
My Forecast to November
I think the highest-probability scenario is a "wait
and see" by institutional investors. That means to me that the
S&P will range trade between 1150 and 1250 for the next 3
months, in waves of pessimism and optimism, until more visibility
on GDP, jobs, cap ex, manufacturing, and corporate earnings rolls
in.
Remember, this is going to get worse before it gets
better. The downward earnings estimate revisions have not yet
begun to roll in.
And while we want to believe in some good news,
there is likely more bad news to come in the form of bank and
country downgrades, hedge fund implosions, and margin calls in
commodities. These will all be next week's headlines.
So, your focus needs to be on raising cash during
rallies and careful stock-picking with stocks I call "earnings
machines." For example, one of my favorite industrial names,
Cummins (CMI) held up pretty good yesterday versus the rest of the
market by closing above its June lows.
See how I play sell-offs on favorite names when
they go on sale by using naked puts. I will be looking for
opportunities to play energy names like Suncor (SU) and CVR Energy
(CVI), tech names like Apple (AAPL) and IBM (IBM), and agriculture
names like CNH Global (CNH) and Potash (POT) when I see the
irresistable combination of oversold stock prices and high put
premiums.
What are the chances that this advance "pricing-in
of the recession" heats up and we dip below S&P 1,100? I'll say
about 40%, right around where I think the probability is for an
actual recession.
Use my probabilities as a rough guide and trade
your own view accordingly. Many strategists from major investment
houses, managing trillions of dollars in aggregate, have similar
projections.
The hard part is that on big sell-off days, they
look like they are more scared than they really are.
Kevin Cook is a Senior Stock Strategist with
Zacks.com
APPLE INC (AAPL): Free Stock Analysis Report
CNH GLOBAL NV (CNH): Free Stock Analysis Report
CVR ENERGY INC (CVI): Free Stock Analysis Report
INTL BUS MACH (IBM): Free Stock Analysis Report
POTASH SASK (POT): Free Stock Analysis Report
SUNCOR ENERGY (SU): Free Stock Analysis Report
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