Weighing the Week Ahead: Will Q2 Earnings Disappoint?

Once again we were on target with the theme for last week — the Friday fireworks.

The calendar quirks put a special emphasis on earnings this week, with the Alcoa "official start to earnings season" coming on Monday.  There is a lot of debate about the upcoming reports and what the results will mean.

Background on Earnings and the Economy

My sense is that most traders and fund managers are economic nay-sayers.   We had some fun last week at Wall Street All Stars, starting with a challenge from my colleague Bob Marcin.  He thinks that decades of economic growth have been basically fueled by debt.  Invited to join in, I offered some arguments on the other side.  Readers might enjoy our differing perspectives, which get right to the basis of differing economic expectations.

This extends to corporate earnings, where the conventional wisdom is pretty skeptical.  There have been more pre-announcements than we have seen in recent quarters, and these have been mostly negative.  The reasons cited have increased nervousness about other companies that have not come to the earnings confessional.

Has the sluggish economy finally caused corporate earnings to decline?  If so, by how much?

I'll offer some more thoughts on this in the conclusion, but first let's do our regular review of the events and data from last week.

Background on "Weighing the Week Ahead"

There are many good sources for a list of upcoming events.  With foreign markets setting the tone for US trading on many days, I especially like the comprehensive calendar from Forexpros.  There is also helpful descriptive and historical information on each item.

In contrast, I highlight a smaller group of events.  My theme is an expert guess about what we will be watching on TV and reading in the mainstream media.  It is a focus on what I think is important for my trading and client portfolios.

This is unlike my other articles at "A Dash" where I develop a focused, logical argument with supporting data on a single theme. Here I am simply sharing my conclusions. Sometimes these are topics that I have already written about, and others are on my agenda. I am putting the news in context.

Readers often disagree with my conclusions. Do not be bashful. Join in and comment about what we should expect in the days ahead. This weekly piece emphasizes my opinions about what is really important and how to put the news in context. I have had great success with my approach, but feel free to disagree. That is what makes a market!

Last Week's Data

Each week I break down events into good and bad. Often there is "ugly" and on rare occasion something really good. My working definition of "good" has two components:

  1. The news is market-friendly. Our personal policy preferences are not relevant for this test. And especially — no politics.
  2. It is better than expectations.

The Good

Despite the negative ending to the week, there was some good news.

  • Home prices are higher according to CoreLogic.  Everyone paid a lot of attention to this source when prices were falling, so it is probably worth a look now.  Mark Perry has a nice chart:

Core1

  • Initial jobless claims  were much better at 374K, down 14K from last week.  The latest data did not include the survey week for the monthly employment report.  Doug Short's chart, showing the data point, the widely-followed four-week moving average, and past recessions, shows why the current battle ground is significant.

Weekly-unemployment-claims

  • Important steps in Europe.  Last week's EU Summit significantly reduces the immediate contagion threat that has affected US stocks.  It improves prospects for European economic growth.  It demonstrates that the process of negotiation and compromise is making some progress.
  • Car sales have been very strong.  This is a strange discrepancy from reported employment figures.  (Via Mark Perry).
  • Central banks did some rate cutting (ECB and China most notably).  The immediate reaction to this was a weaker Euro and a chorus of claims that this proves that central bankers are worried.  I recommend looking more to the actual policies than the commentary.  It is helpful to see the interest rate cuts.

The Bad

The economic data was generally weaker than expected.  This continues the pattern of sluggish growth we have seen for several months. 

  • Lower gasoline sales imply economic weakness.  This is a tricky topic, since behavior changes with lower gas prices.  Doug Short takes on all of the twists and turns and includes this helpful chart:

Gasoline-volume-sales-per-capita-vs-price

  • Libor manipulation.  The story describes actual effects as well as undermines confidence.  This is an interesting interactive source that allows you to see what specific banks were doing at various times.
  • The ISM manufacturing and services indexes both disappointed. Steven Hansen highlights the data as a "recession warning."  We have (yet another) interesting chart from Doug Short, highlighting key points around recessions.  Read the full article to see a similar treatment for the (shorter) service index history.  Doug emphasizes the difficulty in drawing any firm conclusions, but see for yourself:

ISM-Manufacturing-PMI

The Ugly

This week's "ugly" award is about employment, but it is unclear whom should be "honored."

For starters, I understand  that the overall report was disappointing, mildly lower than expectations which had been somewhat elevated by the Thursday estimate from ADP.  The discrepancy was well within the +/- 100K sampling error that is applied AFTER all revisions.

The ugly part of this comes from the attendant media coverage.  Since the stock market declined after the announcement, most sources implied causation.  PBS Newshour ran the employment and stock market stories together.  In my comments at Wall Street All Stars my first reaction was that this was an "anti-Goldilocks" result, not bad enough to assure more QE from the Fed and therefore disappointing to traders.  On CNBC that soon became the theme of the day.  No one seemed to notice the dollar strength and euro weakness — itself enough to account for a 1% decline.

The mistaken media interpretations are both a curse and an opportunity for individual investors.  The emphasis on politics means that we can expect many stories about the terrible jobs situation.  The facts:

Negative

The payroll jobs increase was weaker than expected, and far short of what is needed for a reduction in unemployment and a robust expansion.  That pretty much sums it up.

Positive

The bright spots included gains in hours worked and the hourly wage.  The household survey, thought better at capturing creation of jobs in small businesses, is much stronger than the payroll report.  (Via Scott Grannis).

There are many with a major personal stake in making the economy look as bad as possible.  It is difficult for most investors to remain objective.

The Indicator Snapshot

It is important to keep the current news in perspective. My weekly snapshot includes the most important summary indicators:

The SLFSI reports with a one-week lag. This means that the reported values do not include last week's market action. The SLFSI has moved a lot lower, and is now out of the trigger range of my pre-determined risk alarm. This is an excellent tool for managing risk objectively, and it has suggested the need for more caution. Before implementing this indicator our team did extensive research, discovering a "warning range" that deserves respect. We identified a reading of 1.1 or higher as a place to consider reducing positions.

The SLFSI is not a market-timing tool, since it does not attempt to predict how people will interpret events.  It uses data, mostly from credit markets, to reach an objective risk assessment.  The biggest profits come from going all-in when risk is high on this indicator, but so do the biggest losses.

The C-Score is a weekly interpretation of the best recession indicator I found, Bob Dieli's "aggregate spread." I'll explain more about the C-Score soon.  We are working on a modification that will make this method even more sensitive.  None of the recession methods are worrisome.  Bob also has a group of coincident indicators. Like most of the top recession forecasters, he uses these to confirm the long-term prediction. These indicators are also not close to a recession signal.

There is a lot of activity from the recession forecasters.  The basic summary is that those with the best records still see little chance of a recession in the next six months or so.  The people that get featured  in the press and on TV are sticking by their guns, even though the evidence is mounting against them.

We are now at the end of the nine-month forecast window that the ECRI adjusted to after their September, 2011 call (recession imminent, maybe already here, and unavoidable) seemed to prove wrong.  Since then they have been adjusting indicators and trying to extend the window, which supposedly ends right now — mid-year 2012.  Last week we showed several good updates, repeated in case you missed them:

 This week's recession news includes convincing evidence that the US is not in a recession:

"We find ourselves in the 3rd “summer slowdown scare”, just like 2010 and in August 2011. During this time the perma-bears crank up the alarm bells and we are bombarded with a cacophony of ill tidings that spell the doom of the U.S economy. As we saw in 2010 and 2011 the economic slowdowns turned out to be “soft landings”. Investors scared into the side-lines stared in disbelief as the U.S stock markets roared ahead leaving them behind.

We may well be in the same position now. The permabears are coming out the woodwork."

  •  My one-stop source for understanding recessions.  This will give you a big advantage since most people seem to go by "feel" rather than data.  None of the best sources shows an imminent recession threat, and that is important for earnings.  I am continuing to add to the recession series, reflecting some great research which is still in progress.
  • Looking at the same indicators as the recession dating committee.  The St. Louis Fed provides regular updates, so just save this link.  To use it you must understand that a recession starts at a business cycle peak and includes a significant decline from that peak on four different measures.  If you look at the chart, it is difficult to argue that we have seen a recent peak, not to mention a decline.

Us_monthly

Nota bene – a slowing in the rate of growth is not a peak.  This is the most common blunder of the pop-economist punditry.

 

Indicator snapshot 070612

 

Our "Felix" model is the basis for our "official" vote in the weekly Ticker Sense Blogger Sentiment Poll. We have a long public record for these positions.  This week we continued as "bullish." These are 30-day forecasts.

[For more on the penalty box see this article. For more on the system ratings, you can write to etf at newarc dot com for our free report package or to be added to the (free) weekly ETF email list.  You can also write personally to me with questions or comments, and I'll do my best to answer.]

The Week Ahead

I am not expecting much from the economic data next week, which is partly why I expect the emphasis to be on earnings.

Thursday's initial jobless claims will help to clarify whether last week's good result can be sustained.  That was not part of the monthly employment survey period, so it will deserve special attention.

Normally the FOMC minutes do not provide much enlightenment, but I suspect that we might have a surprise this week.  In the post-meeting press conference Bernanke dodged questions about the difference between projections and policy.  He made a reference to the minutes.  Most observers do not understand organizational behavior, so they might have missed this.  The policy is the official organizational response.  The projections are a collection of individual answers.  We should be watching this with interest for a hint a future Fed policy.

We'll get data on consumer credit (Monday), the trade balance (Wednesday), PPI (Friday), and an update on Michigan sentiment.  I am not expecting anything big from these sources.

Summary:  Watch for a surprise on Wednesday, but mostly we'll be watching earnings.

Trading Time Frame

Our trading positions continued in fully invested mode last week.  Felix is not a range trader, but is excellent at getting on the right side for big moves.  The recent aggressive move is still showing a profit, and Felix is pretty aggressive.

Investor Time Frame

The successful investment strategy differs markedly from trading.  It is especially important to establish good, long-term positions when prices are favorable. Most individual investors seriously underperform long-term results by selling low and buying high.  Most successful professionals, of course, do the opposite.

This is easier said than done.  With everyone on TV explaining with great confidence what just happened (please check out my article on the "message of the markets") it is easy for the average person to think he is out of step.

There is no magic moment.  Resolving market worries is a process, not an event.

I tried to explain the most important concept for individual investors in this article about the Wall of Worry. I have had many emails from people who had a personal breakthrough in their investing when they understood this concept. If you missed it, I urge you to take a look.  You can contrast this with the many  pundits who claim miracles of market timing.

The best strategy through the various gyrations has been buying dividend stocks and selling calls for enhanced yield.  Anyone unhappy with bonds should be doing this for a yield of 8-10% with greater safety than pure stock ownership.  Take what the market is offering!

Final Thoughts on Earnings

We are in a multi-year period of improving earnings with lagging stocks.  The explanation typically is that earnings cannot be sustained for one of several reasons:

  1. Profit margins are at a peak and will return to "normalized" levels.  This has a great sound to it, but the implied reduction in productivity will be accompanied by more hiring.  (See here).
  2. A recession is imminent.
  3. Europe or China is about to collapse.

Meanwhile, none of the data has ever supported these arguments, which remain completely theoretical.  Brian Gilmartin, writing in his new blog Fundamentalis, explains it very well:

"Coming into the start of q2 ’12 earnings from Alcoa on July 9th, expectations are very subdued, and the growth outlook is modest at best, so even if guidance is tepid and warnings are rampant, unless you have a portfolio of high p/e growth stocks, chances are a lot of downside is already built into the market."

Check out the entire article to see his analysis of the history of the regular "bumps" in forward earnings, something that you will not read anywhere else.

A Final Thought about Europe

A year ago the argument was that Europe banks and nations would fall like dominoes with a risk to the entire financial system.  With the most dire of consequences averted, the argument now is that Europe will drag the entire world into a recession.  Before falling for this idea, investors should consider this wisdom from Charles Lieberman:

"Recession in Europe has only a modest effect of domestic growth. Exports account for about 13% of U.S. GDP, Europe accounts for just 20% of U.S. exports and a sharp recession in Europe might lower their GDP by maybe 3%. So the impact of a recession in Europe on domestic growth is 13% times 20% times 3% of GDP, a miniscule number. The real risk was that of a meltdown of their credit markets, which might also cause our credit markets to freeze up. This was considered a severe risk, since memories of the credit freeze of 2008 are sufficiently fresh. Still, such an event requires that European leaders would fail to address the problems and would allow them to fester until they explode. Such an outcome was possible, but not overly likely. Once again, European leaders have stepped up to relieve the pressures."

 

June Employment Report Preview

We rely too much on the monthly employment outlook report.  It is a natural mistake.  We all want to know whether the economy is improving and, if so, by how much. Employment is the key metric since it is fundamental for consumption, corporate profits, tax revenues, deficit reduction, and financial markets.

Since the subject is so important, most people place too much emphasis on the official (preliminary) report, which is really only an estimate.  In about eight months, we'll have an accurate count from state employment offices, but by then no one will care.

There are several competing methods that provide independent approaches to analyzing employment.

I will first summarize the BLS official methodology.  Next I will review alternative approaches and those forecasts.  I will conclude with some ideas about what to watch for.

The Data

We would like to know the net addition of jobs in the month of May.

To provide an estimate of monthly job changes the BLS has a complex methodology that includes the following steps:

  1. An initial report of a survey of establishments. Even if the survey sample was perfect (and we all know that it is not) and the response rate was 100% (which it is not) the sampling error alone for a 90% confidence interval is +/- 100K jobs.
  2. The report is revised to reflect additional responses over the next two months.
  3. There is an adjustment to account for job creation — much maligned and misunderstood by nearly everyone.
  4. The final data are benchmarked against the state employment data every year. This usually shows that the overall process was very good, but it led to major downward adjustments at the time of the recession. More recently, the BLS estimates have been too low. (See here for a more detailed account of this, along with supporting data).

Competing Estimates

The BLS report is really an initial estimate, not the ultimate answer. What we are all looking for is information about job growth. There are several competing sources using different methods and with different answers.

  • ADP has actual, real-time data from firms that use their services. The firms are not completely representative of the entire universe, but it is a different and interesting source. ADP reports gains of 176K private jobs on a seasonally adjusted basis.  In general, the ADP results correlate well with the final data from the BLS, but not always the initial estimate.
  • Economic correlations. Most Wall Street economists use a method that employs data from various inputs, sometimes including ADP (which I think is cheating — you should make an independent estimate).
    • Jeff Method.  I use the four-week moving average of initial claims, the ISM manufacturing index, and the University of Michigan sentiment index. I do this to embrace both job creation (running at over 2.3 million jobs per month) and job destruction (running at about 2.1 million jobs per month). In mid-2011 the sentiment index started reflecting gas prices and the debt ceiling debate rather than broader concerns. When you know there is a problem with an input variable, you need to review the model. For the moment, the Jeff model is on the sidelines.  From my perspective, the decline in consumer confidence, even with lower gas prices, is disturbing.  It is difficult to account for the effect of headlines about Europe and the fiscal cliff.
    • Street estimates generally follow my method, but few reveal much about the specific approach.  Have a little fun by looking at the specific forecasts from many firms, along with a picture of the spokesperson!  Thanks to Business Insider.  Joe Weisenthal, in a good story about Goldman,  notes that some of these estimates are already responding to the ADP report.
  • Briefing.com cites the consensus estimate as 100K, the same as their own forecast.
  • Gallup sees unemployment as falling on a seasonally adjusted basis (but flat if unadjusted).  This is interesting since they have a different survey from the government, a relatively new approach to seasonal adjustment, and an extremely bearish and political approach in past commentaries.  Gallup's methods deserve respect, so I am watching closely.

Partial Indicators 

A problem with forecasting net employment changes is that you need to look at all of the following:

  1. Both hiring and firing;
  2. Companies of all sizes; and
  3. Failing companies and new businesses.

There are many interesting pieces to the puzzle, but it is easy to over-react without the context listed above.  The respected Challenger survey reports fewer layoffs.  Excellent!  But does that mean hiring?  Initial jobless claims move higher.  That tells us about job losses at certain types of firms, but nothing about job creation.

An interesting idea comes from Michael Mandel, who astutely notes the disparity in help-wanted ads according to the occupation.  Harkening back to The Graduate, Michael (one of my favorite acquaintances from my Kauffman meetings), writes as follows:

"If you have a college student in your family who is looking for a job, remember this one word: 'Data.'"

For Dustin Hoffman it was "plastics."  Michael says to watch this, so I am and you should, too.

Men on a Mission

(And women too, of course, but I could not resist the alliteration.  Biased female economists should feel free to accept equal blame!)

Here at "A Dash" we have great respect for those who make objective, independent forecasts.  We know that methods may lead to different conclusions, and that debate is healthy.

With this in mind, here are two examples:

  1. TrimTabs confidently asserts that the BLS data will be wrong!  Amazing, without knowing the content of the report or the revisions.  They assert that we are in a "depression" and are confident about the direction of later revisions.  While I have been sympathetic to their own mistakes, and agree about revisions, they do not seem to realize that the BLS has been understating growth for a couple of years.  Why the agenda?
  2. David Rosenberg is out with a list of reasons why the jobs report will "stink."  He cites a number of interesting indicators.  A serious economist would do research with a time series on each, discarding those that reflected multi-collinearity.  That is what my team did.  He cherry picks reports and plays the same tune, always finding new data.  He has an audience, and one much bigger than mine!  [Will someone please remind me of who first said that the crowd expects Neil Diamond to sing Sweet Caroline?  I want to give credit where it is due.]

Failures of Understanding

There is a list of repeated monthly mistakes by the assembled jobs punditry:

  • Focus on net job creation.  This is the most important.  The big story is the teeming stew of job gains and losses.  It is never mentioned on employment Friday.  The US economy creates over 7 million jobs every quarter.
  • Failure to recognize sampling error.  The payroll number has a confidence interval of +/- 105K jobs.  The household survey is +/- 450K jobs.  We take small deviations from expectations too seriously — far too seriously.
  • False emphasis on "the internals."  Pundits pontificate on various sub-categories of the report, assuming laser-like accuracy.  In fact, the sampling error (not to mention revisions and non-sampling error) in these categories is huge.
  • Negative spin on the BLS methods.  There is a routine monthly question about how many payroll jobs were added by the BLS birth/death adjustment.  This is a propaganda war that seems to have ended years ago with a huge bearish spin.  For anyone who really wants to know, the BLS methods have been under-estimating new job creation.  This was demonstrated in the latest benchmark revisions, which added more jobs, as well as the most recent report from state employment offices.

It would be a refreshing change if your top news sources featured any of these ideas, but don't hold your breath!

Trading Implications

My experience with employment Fridays is that there is little benefit to being aggressively long before the report.  The spinfest usually provides shorts with a morning "dip to cover" when the number is surprisingly good.

I also expect some dampening in either direction.  A really bad number will be met with expectations for Fed action.  A strong number will get the opposite result, and maybe a stronger dollar.

Unless there is a massive discrepancy from expectations, my guess is that we will move on to earnings season and option volatility will be reduced.

And most important…..investors should not let this become political, even though the pundits will.

Progress, Technology, and Economic Fundamentals

There is a popular idea that economic growth only comes from stimulus.  Wrong!

This mistaken view of economics can be costly to the average investor.  The US economy, and others that follow a free market approach, grow through population increases and productivity gains.  Normal trend growth in the US, allowing for inflation, is a bit over 3%.  Even in the absence of any stimulus, we would eventually get there as various factors reverted to mean levels.

This is difficult to explain without a full course in economics, so today I will offer an alternative approach.  Any reasonable person can see the changes in societal well being, but it is easy to forget.but there is a thriving industry claiming that traditional economic statistics overstate the economy.

Let us consider a simple example that we can easily understand as a starting point.

A Simple Example

I was already thinking about this subject last week because of a promotional item that I received in the mail.  It reminded me of an interesting theme of progress — the calculator.

When I was a college student, we used slide rules for calculation.  I was a student engineer at Union Carbide.  They had a few mechanical calculators that did rudimentary functions (with a lot of noise).  The calculators were perched between two desks, shared by the engineers on either side to save on costs.

Images

A few years later I was a quant guy in the Michigan PhD program, hoping for my own calculator.  They now had electronic versions, and some could perform the basic math functions and even store a value in memory.  That was my minimum spec, and I wanted one for less than $100.  That would be the equivalent of over $500 today.  The price point was finally met with a device about the size of a paperback book, requiring a few C batteries to power it.

09bfdbb2c4e374aab59205556da37eb6_1M.png

Both of these devices were major improvements, increasing user productivity tremendously.  Before that, we wrote down columns of figures and did the math by hand.

The same engineer could do much more work because of the improvement in technology – – a simple concept.

My alert readers have already guessed the conclusion of this little story.  The promotional item in the mail was a featherweight calculator, superior in function to the model depicted above.  It has a small battery that will last forever.  Best of all, it was free.

And this theme does not even explore the added value of the spreadsheet or computer programs that combined the required calculations.

And Now …. Add the Internet

Thanks to Al Gore (!!) we now have a new dimension of productivity.  I am astounded to discover that there are more iPhones sold each day than babies born, and I don't suppose that the 15 minutes of porn watching adds to productivity, but those are just the sidelights.

I can do work in minutes that would have taken days in a library a few years ago.  Take a look at these interesting facts from MBAOnline.com and I'll provide an investment idea in the conclusion.

 

A Day in the Internet
Created by: MBAOnline.com

All of this would have been unthinkable a few years ago — an explosion in communications and information access.

Investment Themes

There are several important ideas to think about.

  • Economic growth is fueled by technological progress.
  • Every major corporation has improved business with improved robotics, communication, planning, customer acquisition and service, logistics, supply chain, and I'm just getting started.
  • These elements are part of the explanation for high profit margins, and also for the recent success of some companies in bringing jobs back from offshore.
  • While it is easy to forget, the quality of life is better through progress — better in agriculture, motor vehicles, clothing, health care.

Those with offbeat theories of economics need to explain this progress.  The rest of us can enjoy investing in companies that participate in economic growth and the technology companies that help to create it.

My current tech favorites are Apple (AAPL), Oracle (ORCL), and Microsoft (MSFT), but I also like innovative companies in medical devices.

I invite readers to weigh in with their own favorites!