July 25, 2011
The current earnings season is off to a promising start. However, the rate has been trending lower, and so has the size of the surprise.
Despite the constant media drubbing of global debt concerns (both those of Greece and the U.S.), we continue to see the potential for further rallying.
Our current approach is to maintain a generous exposure to global equities, inclusive of U.S. stocks, and to continue gauging the weight of evidence as the market navigates through the earnings season and other uncertainties.
If a debt-ceiling deal is not passed in time, and the debt is downgraded, the consequences could be dire and unpredictable. It would make investing decisions more complicated, but potentially much more profitable give the likelihood of volatility and re-pricing.
Earnings Scrutiny
The second quarter earnings season could say a lot about the stock market’s resilience. A successful season could spur another decisive market up leg. A season of disappointment could weigh down the rally’s progress, or even push it into a downtrend.
Over the four quarters (i.e. earnings seasons) ending in March 2011, operating earnings of S&P 500 companies came out well ahead of earnings estimates that had been expected a year prior. Also, the rate of earnings surprises ran well above the average beat rate (the rate at which company earnings reports beat estimates) of 62.5% since 1994. The current earnings season is off to a promising start. However, the rate has been trending lower, and so has the size of the surprise.
Would the stock market tolerate a less favorable earnings season? Perhaps so, if investors maintain the view that economic growth has been through a soft patch that is giving way to strengthening in the year’s second half, supporting earnings growth to come. Our expectations support the optimistic view, having yet to reflect much deterioration in the earning environment. Under the more favorable scenario, the stock market would be likely to allow multiple expansion to reach at least twenty (20) on the median price-to-earnings ratio (P/E) in the S&P 500. That P/E is the average since 2000 and the approximate level at the cyclical peaks in 2000 and 2007.
Despite the constant media drubbing of global debt concerns (both those of Greece and the U.S.), we continue to see the potential for further rallying. We contend that the April-June selloff was contained as the markets absorbed the significant uncertainty of the aforementioned debt issues, the end of QE2 (the second-round of the Federal Reserve’s quantitative easing program), and weak employment. As the S&P 500 bounced off the 1,258 support level, breadth showed thrust-like conditions (exhibiting Demand) – arguing that the stock market be given more upside leeway. We are willing to give a bullish strategy the benefit of the doubt, but that strategy is on a short leash to prove itself.
If the earnings season turns sour, the markets may consider valuations stretched at current levels. Under the negative scenario, the markets would dismiss the soft patch case and see the economic slowdown turning into much harder landing than currently expected. Another possibility is that European debt problems would evolve into a full-blown financial crisis, itself a potential negative influence on economic and earnings growth.
Allocation Strategy
Our current approach is to maintain a generous exposure to global equities, inclusive of U.S. stocks, and to continue gauging the weight of evidence as the market navigates through the earnings season and other uncertainties. With pessimism higher than optimism (a contrary indictor for the market’s strength) and stock price valuations fairly neutral, we would not underestimate the market’s potential to look beyond immediate concerns and continue to rally on the prospects for an economic soft patch to give way to renewed economic momentum ahead.
We would likely, for more growth-oriented portfolios, increase U.S. equity exposure in response to confirmed break-outs above the market’s April highs.
And what if together with the other concerns, the earnings season turns out to be too much for the markets, which fail to rally sustainably and instead break back below the March-June lows? In that case, with the indicator evidence likely consistently negative by then, we would consider reducing equity exposure.
For those watching the technical chart patterns, we acknowledge that the highs of February, April, and July appear to diagram the menacing appearance of a head-and-shoulders topping pattern. But currently we give the benefit of the doubt to a more bullish strategy, while remaining flexible. Flexibility, as opposed to maintaining a rigid strategy, allows us to remain prepared to get more bullish in response to improving indicator evidence or more bearish if conditions deteriorate.
What are the Consequences of a U.S. Default?
On signs of progress of a deficit deal, long-term Treasury yields move near their lows. If a credible deal is passed, we would expect very little volatility in and a continuation of very low yields for Treasuries.
If a deal is not passed in time, and the debt is downgraded, the consequences could be dire and unpredictable. Long-term yields would rise and the yield curve would steepen as longer-term maturities move down in price and up in yield, since longer maturity instruments would face the risk of future defaults. (The sentiment of “they’ve done it before, why wouldn’t they do it again” would take hold.)
The U.S. dollar would be under pressure.
Under the category of “unpredictable”, keep in mind that Treasuries are the backbone of pricing. If they are no longer triple-A would they still be used to price other securities, or would only triple-A securities be used? What would it do to the Capital Asset Pricing Mode, which assumes a risk-free rate based on Treasury securities? Would there be a risk-free rate anymore, or would it move to another triple-A rated country, such as Canada?
Repos (which is short for the “repo market”, are contracts for the sale and future purchase of a financial product, most often Treasuries) and other credit channels that require collateral would shut down, causing credit markets to freeze and liquidity to evaporate.
Interest costs on the federal debt would rise, making the budget deficits worse.
Since nobody really wants to see a repeat of the financial crisis when Lehman and AIG failed, market participants still expect a deal to get done. Politicians, we hope, understand that the consequences of a downgrade are too painful to contemplate.
Bottom Line: We have received many telephone calls regarding the looming debt ceiling deadline. Just as during the financial crisis of 2008-2009, Berkshire Money Management is more concerned about the investment ramifications than anything else. If we can set aside patriotism as well as concerns for what happens to non-investors, a U.S. default and a subsequent downgrade would create investment opportunities; investment options would be obvious (reduce risk); the stock market would fall in the short-term due to fear and confusion, allowing for a re-pricing rally in the intermediate-term.
If a debt-ceiling deal is not passed in time, and the debt is downgraded, the consequences could be dire and unpredictable. It would make investing decisions more complicated, but potentially much more profitable give the likelihood of volatility and re-pricing.