The Stock Market: Economy over Earnings

Morris Segall      aborted stock market rally, consumer sentiment, oversold stock market rallies, peaking in corporate earnings cycle, pessimistic Fed outlook

In our July 6th website article, “Economic and Capital Markets Update”, we concluded our bearish forecast with the advice, “we would use an anticipated market rally in July from good second quarter corporate earnings to move towards our intermediate-longer term strategy”.  Despite our negative assessment of the economic data of the last two months and our downgraded economic forecast for next year, we expected the combination of an oversold stock market and strong second quarter corporate earnings reported in July, would produce a strong equity market rally that we would use to sell equity positions in favor of the re-allocation we advocated for the intermediate-longer term. As if on cue, the equity market rally we were expecting arrived the next day, July 7th, as the major U.S. equity market averages rose approximately 3%. Over the next five trading sessions, the major averages added another 3%-4%, peaking on July 14th on the backs of strong earnings from major bellweather companies like Alcoa, CSX and particularly Intel. However the economic news released last week continued a string of weak reports including retail sales and industrial production for June, a pessimitic Federal Reserve economic outlook and finally another collapse in consumer sentiment, this time in the University of Michagan survey reported on Friday. The weakening economic data and outlook  undermined the earnings rally and accompanied by weak operating earnings from major international banks, the stock market rally of July 7-14 reversed with a 3% decline in the major averages on Friday. Importantly, the rallies in virtually all of the major U.S. equity indices failed at or around the 50% retracement from the June market lows, a key development for market technicians and traders who now believe the aborted rally at such a key technical level spells the end of the July rally and a resumption of the market decline begun this past May.

From a technical standpoint they may be right. From an economic standpoint they could also be right. The stock market is a forward looking mechanism and the increasingly weak economic data being reported look like it is corroborating our stated belief that the economy is stalling. The Fed’s downwardly revised economic outlook and the huge decline in consumer sentiment in both the Conference Board and University of Michigan surveys portend the kind of economic retrenchment we warned about in our July 6th website article. The consumer sentiment readings are particularly worrisome because they reflect a deep level of pessimism that can be a self fulfilling contraction in consumer spending, already weak in this recovery. We still expect a summer spike in consumer spending from increased vacation travel and we think it may provide another oversold rally in the equity markets when reported in August and September. However, the stock markets could be at or below the June lows when the news hits and the economic outlook for late this year and next could have eroded further.  This week will be crucial to see whether Q’2 earnings can halt the market reversal and give investors a better exit point. We still believe stock market rallies in July or later should be sold into. The stock market uptrend from March, 2009 is over.  Current earnings no matter how strong cannot outweigh a deteriorating economic outlook that portends a peaking in the earnings cycle over the next four quarters.

Morris R. Segall, CFA, CIC