Another Week Of Gains

(originally published on December 8, 2007)

Technorati Tags: foreclosures,S&P 500 earnings,SIV,unemployment

 

Following up on the strong surge the previous week, the front-line indexes stacked up a further near 2% gains this week. The sentiment, in the equity markets at least, was also helped by surprise rate cuts by the Bank of Canada and Bank of England, signaling a significant loosening of monetary policy across the globe. After a steady decline for the better part of November, the front-line indexes have staged a remarkable rebound from near-term oversold levels over the past two weeks.

 

S&P 500 - Daily

 

Nasdaq Composite - Daily

 

Equity investors have a habit of jumping up on shadows and losing out on profits. However, not all shadows are caused by imaginary monsters. While the bounce has caught most by surprise, there are strong headwinds that are likely to stall any further advance.

Markets are still trading a fair distance away from their prior peaks even after a 75 basis points rapid-fire reduction in interest rates. Historically, this has not augured well for the health of the equity markets. A notable change in market character (several large 200-300 points up/down days on the Dow) suggests distribution by risk-averse smarter hands.

With nearly all the companies having reported their 3QCY'07 results, cumulative earnings for the S&P 500 registered a 2.5% decline, for the first time in five years. Operating earnings for the S&P 500, stripping out the various write-downs and charge-offs, declined a sharp 8.5% in 3Q, a far cry from the 9.6% growth seen in 2Q and the 11.6% increase a year ago. The 12.4% sequential decline in earnings in 3Q is the worst performance for almost two decades, rivaling similar earnings declines in 4Q of 1989 and 4Q of 2000, that preceded the previous two recessions. This disastrous showing has led to analysts significantly paring down their estimates for 4Q and beyond.

 

Steady downward revisions in forward earnings estimates for S&P 500

 

With a high likelihood of further write-downs in 4Q, we are possibly staring at the abyss of an 'earnings recession'. It is unclear at this juncture whether this will turn into a full-blown 'production recession'. Nevertheless, an earnings recession is a serious problem as it is profits that drive the entire business cycle. Yet, neither government nor central bankers can actually create earnings power for corporates. Financial markets are still in a disbelief mode, refusing to gauge the extent of the problems and taking heart in minor near-term drivers. There has not been an expanding wave of pessimism that typifies market troughs. The coming week with a key FOMC policy meeting will thus be a litmus test for bulls; it will help us judge better whether this liquidity-led, catalyst-driven bounce off oversold territory is likely to sustain.

This week, we look at how foreclosures are quickly becoming the focal point of US politics in an election year. We then dissect the jobs data to see whether the job market is indeed holding up strongly as indicated. We finally wrap with an account of how SIVs are becoming a real pain in the balance sheets for banks.