Friday, July 31, 2009

Global Markets July Review: Rally Without A Cause?

Or, The Importance of Beating Earnings…However You Do It


In mid-July markets were just beginning to stabilize after falling hard in late June and early July. The mood was grim, as a mixed economic picture was getting darker, due to

  • a downward revision of economic forecasts from the World Bank

  • a much worse than expected monthly US Non-Farms Payroll decline

    Against the backdrop of mixed economic news and risk assets at 2009 highs, the expectations of a rapidly approaching recovery that supported this rally seemed unrealistic. So stocks dropped, and virtually all risk assets followed, though to different degrees. The more volatile, like crude oil, dropped almost 20% from their highs.

    The declines slowed before the start of US second quarter earnings, as it was clear that these would provide the next market moving evidence about the world economy.

US Second Quarter Earnings Season Sparks Rally in Global Risk Assets

Even before the big name announcements, global stock markets began rallying hard Monday July 13th based on a New York Times article that predicted US investment banking giant Goldman Sacks (GS) would beat expectations.

The fortunes of the major US financial institutions have been at the root of every major stock market move over the past two years. The current economic crisis began with their subprime lending woes, and worsened with the collapse of Bear Stearns and Lehman Brothers. Stocks began their first serious rally with first quarter earnings reports in early March, when the major banks showed profits, albeit of questionable legitimacy and less likelihood of repeating.

Thus the mere rumor that GS, and by extension the other major banks, could be healing was enough to ignite another rally. Most other earnings reports followed with similar good news, especially those from the leading firms in various sectors.

The Rally's Basis? Bad Results Beating Worse Estimates = Good Times Ahead

However, the picture was far less rosy. Yes, most firms beat estimates, but most of these did so with declining revenues and/or earnings that managed to exceed even grimmer analyst expectations. Not one of the banks beat estimates based on steady ongoing operations. Goldman Sachs did it with high risk trading that by nature cannot be depended on to produce steady results. The others did it via one-time gains on asset sales. Citibank (C) would have shown a loss had it not sold its Smith Barney operation to Morgan Stanley (MS). All acknowledged rising "credit risk, " meaning that the value of their loan portfolios was likely to drop. Most showed losses from every aspect of their ongoing operations.

Outside of banking, there was also a large majority of firms exceeding analyst estimates, but again, mostly with bad results beating even lower expectations.

In sum, stocks rose, yet revenues and actual earnings from ongoing operations are mostly in a down trend. Because the downtrend was less steep than expected, the markets took that to mean bottoming and growth were on the way.

Commodity and forex markets followed stocks higher, though to varying degrees. Like stocks, the highest yielding and commodity based currencies hit or approached former highs against various crosses. However, crude and gold rose less.

Today's US GDP could be the trading opportunity of the week

With the theme of "bad results beating worse estimates = immanent recovery" already established, even new earnings announcements feel like old news and are failing to surprise the markets. Instead, traders are now refocusing on the weekly economic calendar and other key news events for direction

The next big news is US quarterly GDP figures, due out at 8:30 EDT, or12:30 GMT.

How Will Markets Respond to US GDP?

For short term and news oriented traders, this is the big opportunity to catch the market moving. The forecast is for an annualized contraction of 1.4%.

If GDP results are worse

Given that stocks and other risk assets have risen substantially over the past weeks with questionable justification, a pullback would be the likely result.

On the other hand, the markets have shown a remarkable ability to ignore bad news. Thus it's conceivable that if the figures are only mildly worse, there could be minimal or even no real pullback. No, that doesn't seem rational, but neither does the rally we've seen thus far.

If the numbers are much worse, they could undermine the "less bad = soon to be good" theory that underlies this rally. If that's the market's interpretation, then at least a test of Mid July lows would not be surprising. Some analysts have predicted that a 20-30% pullback could occur while still retaining a mild up trend from the March lows.

In fact, much would depend on the context of other events, especially further news on the jobs growth and the financial and housing sector's health.

If GDP results are in line with the expected 1.4% annualized decline

Again, given the markets' recent focus on the positive, that might be enough to at least keep stocks and other risk assets at or near current levels. On the other hand, with markets already extended, this might be enough to spark at least some profit taking.

If GDP results are much better than expected

Because traders have made so much of a rally based on so little justification, markets could easily take another great leap forward. However, with markets already so high, could this be seen as chance to cash out, and cause at least a short term pullback?

Coming Events & Conclusion

There are some major events next week, such as statements from a variety of central banks. Of particular interest will be that of the Bank of England, to see if there is further QE on the way after the UK's much worse than expected GDP figures. Good results from the US GDP numbers could lend support to those seeking more liberal QE policy.

However, the big news of the coming week will likely be US Non Farms Payrolls data. Last month, it was disappointed enough to knock global markets, that were at or near their highs for the year, into a 2 week decline that could have gone further were it not for US Q2 earnings results.

Once again, world markets are at or near the upper end of their trading ranges. If they survive US GDP later today, non farms payrolls could be their next test.

Disclaimer: The opinions of the author are not necessarily those of AVAFX
Disclosure: The author may have positions in the above instruments.

No comments:

Post a Comment