Introduction: New Forces Driving Global Asset Markets
What a difference 2 weeks makes. Don't be fooled by the below daily chart of the S&P 500, which appears to show nothing more than a 2+ month trading range with little net change since mid May
Because the level of optimism about global economic prospects has been best reflected in major stock indexes, especially in the most representative stock index of the biggest economy, the S&P 500 Index, we look at it to begin our review of the past half month and preview of the clues it holds going forward.
Chart 1:S&P Daily Chart: A Trading Range Belies the Underlying Changes Over the Past 2 Months
Despite the sedate appearance of the oscillations within this trading range, there has been profound change.
To paraphrase the opening lines of film The Fellowship of the Ring, (please imagine your own ominous background Lord of the Rings soundtrack):
"The markets have changed. You can feel it in the news, and in the air. You can see it in the correlations between the trader sentiment, the news, and the charts."
Background: A Brief Chronology and Interpretation
Here's a review of recent events.
Q1 Bank Earnings Spark a Rally in Stocks, Commodities, and Currencies
In the beginning of March, in the depth of gloom about the economy in general and the stability of the US and thus world financial system in particular, US banks reported unexpected Q1 profits, igniting a rally that peaked in early June around 945 on the S&P. Global commodities and riskier currency pairs broadly followed this trend and the movements described below.
With Earnings Season Done, News Becomes the Driver of Sentiment, Stocks, Currencies and Commodities
The rally had stalled a bit above 800, to be revived by the Washington's announcement of the PPIP, a plan to allow banks to both dispose of their bad assets and buy other bad assets at very little risk with Washington essentially guaranteeing the banks against losses they might incur thus guaranteeing profits.
Thus the rally resumed, and in the process forced quant fund programs to trigger stock purchases to unwind their short positions, thus further feeding the rally until it stalled, then made a last lunge at 945, typical of the 20-30% or more rise that major global stock, currency, and commodity markets achieved as they moved up more or less in sync along with the S&P .
Economic News Doesn't Support the Gains, Global Markets Drop
Because recent economic news in late May through Mid June had been at best mixed, traders questioned whether there would really be similar gains in employment, GDP, earnings, or any meaningful metric of growth within the coming year. Global stocks thus reflected that fear and spent this period in a tight trading range near their highs for 2009, testing a bit lower and oscillating back up.
Then came the World Bank's downward revision of its global economic forecast on June 22. International stock index traders, already nervous, sold off as the scales now seemed tipped toward a later, weaker recovery. Stocks then recovered their June 22 losses, helped in part by a counterbalancing OECD upwardly revised forecast.
The main difference in opinion was that the OECD held the US would grow enough to compensate for the admittedly weaker GDP elsewhere.
Then came the Thursday July 2nd US non-farms payroll data, which confirmed that the US jobs picture was not improving and that the US consumer, whose spending is about 70% of the US GDP, was getting poorer as average hourly wages were flat and average hours worked were declining.
Thus prospects for a stronger US recovery seemed dimmer, and that directly undermined the OECD report.
In the context of the conflicting economic news, this report seemed to have more decisively tipped the consensus toward belief in a more distant, weaker recovery what stocks had priced in. Stocks fell again, erasing their recent recovery. After the long 4th of July weekend in the US, world markets again fell hard, forming a new downtrend.
Another downgrade of the global economy, this time from the IMF, only added to the gloom.
To see an example of how well synchronized currencies and commodities have been with stocks, note the correlation of some representative 1 day commodity and currency pair charts with that of the S&P chart on and shortly after the July 2nd US payroll data came out.
Chart 2: Currencies, Commodities Have Been Moving with the S&P (Lower Left)
Q2 Earnings: The Last Stand?
The last near term hope was the impending Q2 earnings season. If earnings and Q3 guidance could show a clearly positive or negative theme, it could greatly influence the next multi-month market move, as was seen from the Q1 announcements.
Once again, the most important announcements and guidance would come from the financial sector, the root of the all major market moves over the past two years as well as almost every recession since the early 1980s. Remember the Latin American Debt Crisis? Guess who lent them the money? Remember the Savings & Loans crises of the early 90s? Perhaps the financials were arguably not the key to the dot com bust (but who was underwriting and promoting the IPOs and communications infrastructure build-outs of firms lacking the income to justify the investment?). However, their sub-prime lending and securitization of this dubious debt sure created this one.
Those traders who study chart patterns should look again at Chart 1 above. Note how the S&P was poised at 876, at the brink of the neckline of a bearish head and shoulders pattern that suggested high potential for continued downtrend.
The Importance of Beating Earnings (Estimates): Stocks Again Go from Merely Reflecting Sentiment to Creating It
That is the change in the dynamics of what moves world stock, currency, and commodity markets during earnings season. In the absence of other strong competing news, stocks become more of an independent force acting on other asset markets rather than a mare leading indicator or best indicator of trader sentiment.
On July 13, The New York Times reported that Goldman Sachs (GS) would beat estimates when it reported Q2 earnings on the 14th. That news alone sent the S&P and other markets soaring. The following day GS indeed beat earnings expectations before the market opened. After the close of July 14th trading, Intel also beat earnings expectations, feeding further rally in Asia, where much electronic and chip manufacturing is done.
Moving more or less in synch, commodities, commodity-based currencies, and higher yielding currencies followed and started to climb off of multi-month lows. Safe haven currencies like the JPY, USD, and CHF, which had been gaining against the others, began to drop.
As of this writing, JPMorgan Chase (JPM) did the same, potentially providing more lift for the rally.
Earnings season is still young, so it's too early to offer anything more than tentative thoughts. These include:
If GS and JPM are beating earnings estimates, it becomes that much more likely that Bank of America (BAC) and Citigroup ( C ) will bring home good news, and so for the other big name financials. If the theme from the financial sector earnings is positive, it greatly reduces the chances of a near term down trend to test November or March support levels. If the overall theme of earnings season is positive, that likelihood diminishes further still.
Conclusion: A New Rally Foretold? Or Back Home on the (Trading) Range?
It's clearly too early in earnings season to say, and there have already been plenty of big name earnings misses. Even if the overall theme from earnings is positive, since stocks and other risk assets have already significant highs logged for the year, those highs will be tough to surmount as long as jobs and consumer spending doesn't start to show real improvement.
In addition, there are plenty of potential landmines that could douse the current optimism. Just a few include:
1. The possibility is growing that commercial lender CIT could go bankrupt, leaving thousands of businesses without credit lines.
2. Enough bad earnings reports, and there are already a healthy share of those out so far.
3. More bad news that dampens consumer spending, like unanticipated job losses or spending drops.
Of course, the above doesn't even begin to address the deeper long term problems still facing the banks, like increasing job losses and their affects on bank residential and commercial mortgage portfolios, credit card debt, etc.
In short, a new downtrend has become less likely, a new test of recent highs in stock indexes, higher yielding and commodity currencies and commodities appears more likely. In sum, we may well have a return to the trading ranges established over the past 2 months, as markets await further developments.
Disclaimer: The opinions of the author are not necessarily those of AVAFX
Disclosure: The author may have positions in the above instruments.