A Looming Catastrophe Ahead?

Caroline Valetkevitch of Reuters reports, Wall Street braces for grim third quarter earnings season:

Wall Street is bracing for a grim earnings season, with little improvement expected anytime soon.

Analysts have been cutting projections for the third quarter, which ends on Wednesday, and beyond. If the declining projections are realized, already costly stocks could become pricier and equity investors could become even more skittish.

Forecasts for third-quarter S&P 500 earnings now call for a 3.9 percent decline from a year ago, based on Thomson Reuters data, with half of the S&P sectors estimated to post lower profits thanks to falling oil prices, a strong U.S. dollar and weak global demand.

Expectations for future quarters are falling as well. A rolling 12-month forward earnings per share forecast now stands near negative 2 percent, the lowest since late 2009, when it was down 10.1 percent, according to Thomson Reuters I/B/E/S data.

That's further reason for stock investors to worry since market multiples are still above historic levels despite the recent sell-off. Investors are inclined to pay more for companies that are showing growth in earnings and revenue.

The weak forecasts have some strategists talking about an "earnings recession," meaning two quarterly profit declines in a row, as opposed to an economic recession, in which gross domestic product falls for two straight quarters.

"Earnings recessions aren't good things. I don't care what the state of the economy is or anything else," said Michael Mullaney, chief investment officer at Fiduciary Trust Co in Boston.

The S&P 500 is down about 9 percent from its May 21 closing high, dragged down by concern over the effect of slower Chinese growth on global demand and the uncertain interest rate outlook. The low earnings outlook adds another burden.

China's weaker demand outlook has also pressured commodity prices, particularly copper.

This week, Caterpillar slashed its 2015 revenue forecast and announced job cuts of up to 10,000, among many U.S. industrial companies hit by the mining and energy downturn. Also this week, Pier 1 Imports cut its full-year earnings forecast, while Bed Bath & Beyond gave third-quarter guidance below analysts' expectations.

"We are continuing to work through the near-term issues stemming from our elevated inventory levels and have adopted a more cautious and deliberate view of the business based on our first-half trends," Jeffrey Boyer, Pier 1 chief financial officer, said in the earnings report.

On the other hand, among early reporters for the third-quarter season, Nike shares hit a record high after it reported upbeat earnings late Thursday.

Negative outlooks from S&P 500 companies for the quarter outnumber positive ones by a ratio of 3.2 to 1, above the long-term average of 2.7 to 1, Thomson Reuters data showed.

"How can we drive the market higher when all of these signals aren't showing a lot of prosperity?" said Daniel Morgan, senior portfolio manager at Synovus Trust Company in Atlanta, Georgia, who cited earnings growth as one of the drivers of the market.

To be sure, the vast majority of companies usually exceed their earnings forecasts when they report real numbers.

"This part in the earnings cycle is typically the low point for estimates," said Greg Harrison, Thomson Reuters' senior research analyst. In the first two quarters of 2015, companies went into their reporting season with analysts predicting a profit decline for the S&P 500, and in both quarters, they eked out gains instead.

In the last two weeks, analysts have dropped their third-quarter earnings predictions by about 0.3 percentage point. There was no change in estimates in the final weeks of the quarter in the first two quarters of 2015.

And companies may be snapping their streak of squeezing profits out of dismal revenues. For the first time since the second quarter of 2011, sales, seen down 3.2 percent in the third quarter from a year ago, are not projected to fall as fast as earnings. Companies have been bolstering their earnings per share figures by buying back their own shares and thus reducing their share counts, and that may happen again this quarter.

COSTLY SHARES

Even with the recent selloff, stocks are still expensive by some gauges. The S&P 500 index is selling at roughly 16 times its expected earnings for the next 12 months, lower than this year's peak of 17.8 but higher than the historic mean of about 15. The index would have to drop to about 1,800 to bring valuations back to the long-term range. The S&P 500 closed at 1,931.34 on Friday.

Moreover, forward and trailing price-to-earnings ratios for the S&P 500 are converging, another sign of collapsing growth expectations. The trailing P/E stands at about 16.5, Thomson Reuters data shows. Last year at this time, the forward P/E was also 16 but the trailing was 17.6.

The last period of convergence was in 2009 when earnings were declining following the financial crisis.

The 3.9 percent estimated decline in third-quarter profits - down sharply from a July 1 forecast for a 0.4 percent dip - would be the first quarterly profit decline for the S&P 500 since the third quarter of 2009.

Energy again is expected to drag down the S&P 500 third-quarter forecast the most, with an expected 64.7 percent decrease in the sector. Without the energy sector, the forecast for third-quarter earnings shows a gain of 3.7 percent.

Earnings for the commodity-sensitive materials are expected to fall 13.8 percent, while industrials' earnings are seen down 3.6 percent.

No doubt, stock market investors are bracing for an earnings recession or possibly worse. Akin Oyedele of Business Insider reports, A radical shift is coming to the markets:

The days of double-digit returns are over.

Lisa Shalett, head of investment/portfolio strategies for Morgan Stanley Wealth Management, said at a press briefing on Tuesday that since the end of the financial crisis, investors have enjoyed healthy returns on stocks and bonds, partly because of the Federal Reserve.

But that's about to change.

Shalett said:

"Over the last six and a half years, the S&P 500 has compounded roughly 15%, at the same time that the US bond market has compounded at 9% ... So if you had a balanced portfolio of stocks and bonds, you experienced superior returns, and that portfolio had double-digit returns.

Our outlook is that that balanced portfolio that delivered those double-digit returns probably over the next five to seven years is going to return something a lot closer to four to six percent. "

The Federal Reserve's bond-buying program, known as quantitative easing, together with low interest rates, made it easy for corporations to borrow money and encouraged investors seeking higher returns to invest in riskier assets like stocks.

Now that the stimulus is gone and the Fed is in a "tightening bias" — implying that even if the Fed isn't raising rates it isn't making policy any more friendly for businesses — asset prices could begin to reflect a value that is unsupported by monetary policy.

Indeed, last week was another ugly one hitting many sectors, including high-flying biotech shares which got clobbered on Friday, dragging down the Nasdaq and S&P 500.

Below, I'm going to go over a few sectors and wrap it all up at the end with some thoughts. First, let's look at some ETFs I regularly monitor (click on image):

As you can see, apart from the iPath S&P 500 VIX ST Futures ETN (VXX) and government bonds (TLT), all sectors are now in a downtrend (relative to their 200-day moving average). This doesn't portend well for the overall market and it hardly surprises me that analysts are revising down their earnings estimates as they tend to react to price action, not lead it.

Let me go over some of these sectors below, beginning with the biotech sector since it got slammed the hardest last week weighing down major indices.

Biotech: It was a bloodbath in biotech last week. The week didn't start well with Democratic candidate Hillary Clinton crushing biotech stocks after tweeting  she promised to unveil a plan on Tuesday to take on "outrageous" price increases, referring to this New York Times article.

If you ask me, after hearing her speak, that was much ado about nothing. Still, biotech shares kept getting slammed and it was particularly ugly on Friday afternoon as I watched over 200 biotech shares getting clobbered. Below, I provide you with a list of some of the hardest hit biotech stocks as of Friday (click on image):

Interestingly, among the biggest movers on Friday were two biotech stocks, Bellerophon Therapeutics (BLPH) and Prima Biomed (PBMD) and the short biotech ETFs, namely, the ProShares UltraPro Short Nasdaq Biotech (ZBIO), ProShares UltraShort Nasdaq Biotech (BIS)
and the Direxion Daily S&P Biotech Bear 3X ETF (LABD).

There were plenty of bearish articles pointing out that biotech stocks have fallen into bear market territory as the Nasdaq Biotechnology Index is down more than 22% from its peak in July. The decline is roughly double the losses of the S&P 500 and the Nasdaq over the same period.

If you look at the chart of the Nasdaq Biotechnology Index (IBB), you will see how after it hit an intra-day low of 284 a month ago, it surged higher to its 50-day moving average and then started sinking again, going below its 200-day moving average and it might even go below its 400-day moving average this week which I use to gauge the longer trend (click on chart):

The huge drop in biotech shares is also weighing down the Health Care Select Sector SPDR ETF (XLV) which was one of the outperformers this year but is now in bear territory (click on image):

Despite the vicious selloff, I'm sticking with my call from a month ago, namely that now is the time to load up on biotech. However, I'm looking at that 284 low the biotech index made a month ago and I realize this sector is extremely volatile especially in these Risk On/ Risk Off markets dominated by algorithmic trading (Cramer was right, China could cause biotech stocks to plunge) .

Still, if you ask me, in a deflationary environment, there's a lot more risk in energy and commodity stocks than biotech stocks and even though it's counterintuitive, I'm more comfortable buying the big dips in biotech than bottom fishing in energy and commodities. Despite huge volatility, the former sector is still in a secular bull market while the latter two are already in a deep bear market.

Energy, commodities and emerging markets: These sectors are all inter-related and it's pretty much a China story. Regular readers of my blog know I'm not bullish on emerging markets (EEM), Chinese shares (FXI), energy (XLE), oil services (OIH), metal and mining stocks (XME) and have warned my readers that despite counter-trend rallies, they are better off steering clear of these sectors.

Have a look at the charts of these below which paint an ugly picture as most are already in a deep bear market (click on images).

Emerging Markets (EEM)

iShares China Large-Cap (FXI)

Energy Select Sector SPDR ETF (XLE)

Market Vectors Oil Services ETF (OIH)

SPDR S&P Metals and Mining ETF (XME)

As bad as these charts look, there are plenty of investors betting big on a global recovery. Over the weekend, I read that hedge funds are primed for an oil rebound, increasing their bullish bets. If I were them, I'd pay close attention to what Pierre Andurand is saying as he sees crude prices falling below $30 a barrel.

And if you look at the stocks I posted in my comment on betting big on a global recovery, you will see most keep making new 52-week lows (click on image):

This is why I keep telling you it's better to wait for a turnaround in global PMIs before you stick your neck out and bottom fish in these sectors. If the global economy, especially China, starts showing signs of a turnaround, you will see a major countertrend rally in all these sectors.

Industrials: This sector is also related to China and others mentioned above. In an ominous sign of the times, Caterpillar Inc. (CAT) slashed its 2015 revenue forecast last Thursday and said it will cut as many as 10,000 jobs through 2018, joining a list of big U.S. industrial companies grappling with the mining and energy downturn.

Have a look at the charts of  Caterpillar Inc. and the Industrial Select Sector SPDR ETF (XLI) below and you will see pretty much the same weakness as the sectors above (click on images):

Financials: Interestingly, financial shares (XLF) fared pretty well last week, especially on Friday following news that the Fed might raise rates but on Monday they resumed their downturn and the way markets are heading, I strongly doubt we will see a Fed increase this year which is why I see continued weakness in this sector (click on image):

Related to financials is the retail sector (XRT) which remains relatively weak as most consumers are debt-constrained and petrified of losing their job, putting off spending (click on image):

There is one bright spot for financials, however, and that is housing. If you look at the SPDR S&P Homebuilders ETF (XHB), you will see it's holding up relatively well (click on image):

But Wall Street's big bet on housing isn't paying off and this sector is vulnerable to a rate increase and more importantly, to rising unemployment. So far, the U.S. economy is doing relatively well but that can all change abruptly, especially if we get a market crash.

[Update: The SPDR S&P Homebuilders ETF (XHB) is down almost 5% on Monday after pending home sales tumbled in August.]

Utilities, REITS and dividend yielding sectors: These sectors are sensitive to interest rates and tend to do well as long as the Fed stays put. But even their chats don't inspire much confidence in these markets and they are vulnerable to any good news on the global economic front (click on charts).

As you can see, consumer staples (third chart; ticker is XLP) are doing relatively well in a tough market but in my opinion, this is more of a Risk Off and flight to safety trade than conviction buying.

Bonds: Good old government bonds (TLT) continue to do relatively well and provide investors with the ultimate hedge against deflation and the ravages of markets (click on chart):

What isn't doing well is the high-yield corporate bond market (HYG) and that concerns many investors, including the bond king, Jeffrey Gundlach who has warned the Fed to stay put as long as the junk bond market remains weak (click on image):

Gold will shine again?: If you've been reading Zero Hedge and firmly believe the world is coming to an end and that we're heading to "QE Infinity", then now might be a good time to load up on gold shares (GLD). But I'm not in that camp and think that the latest rally in gold will peter out again once markets stabilize following some good economic news (click on chart):

In fact, as you watch all the gloom and doomers parading on television, pay close attention to this chart on volatility (VXX) below as I think we're in for a bit more pain but things will reverse course fast once it hits its 400-day moving average (click on image):

Conveniently and not surprisingly, this selloff is happening at quarter-end. I would be very careful here not to overreact to what's going on in markets, especially in extremely volatile sectors like biotech which experience sharp selloffs followed by huge rallies.

In the short-run, I expect to see a rally in the S&P 500 (SPY) right back up to its 400-day moving average (click on image):

Whether or not it goes higher remains to be seen as the overall market is weak and there's a risk we will see a major bear market if things go awry from here on.

Below, CNBC's Scott Wapner reports on billionaire investor Carl Icahn's warning of a potential looming catastrophe. Wapner shows an extract of the video going over 5 things that keep Carl Icahn up at night (second clip).

Icahn also spoke with Andy Serwer of Yahoo Finance stating it's going to be a real bloodbath and going over a policy paper on income inequality that the billionaire financier recently sent to Donald Trump and others on Wall Street and in Washington.

In the paper, Icahn warns of “dangerous systemic problems that will affect each and every American in the coming years.” The five and a half page paper has some similarities to the video that Icahn is releasing on www.carlicahn.com, but focuses more on imbalances in our society.

While I agree with Icahn on the buyback bubble exacerbating inequality, take these ominous warnings on markets by hedge fund gurus with a shaker of salt and pay attention to their portfolios, not what they're warning of on CNBC. Icahn is betting big on a global recovery and he's right to hedge as he's losing his shirt on energy and commodity shares.

Hope you enjoyed reading this comment and remember to always breathe in from your nose and out from your mouth when dealing with anxiety from these Risk On/ Risk Off markets. Also, please remember to support my efforts in bringing you the very best insights on pensions and investments via a donation or subscription on the PayPal buttons at the top right-hand side. Thank you!!