James Saft, Reuters Columnist
The S&P 500 is down more than 9% from its October peak, and about 4.5% since election day, prompting much debate over the impact of the impending fiscal cliff, which may hit the economy, and potentially rising rates of taxes on income, dividend and capital gains taxes.
Albert Edwards, the bearish but often prescient strategist at Societe Generale in London, thinks things are quite a bit more simple than that.
“It’s not the impending fiscal cliff the market is worrying about, it’s the actual profits cliff we have already fallen off,” he wrote in a note to clients on Wednesday.
Based on results from the first 428 of the S&P 500 to report, 70% printed results above analysts’ mean estimate, but just 40% made the same hurdle on sales, according to data from Factset. Even worse, the rate of growth at this point is actually -0.1%, which would make it the first time since the recession year of 2009 we’ve had shrinking earnings.
Taken together with a -1.2% revenue growth figure, and you have a picture of a market which, politics entirely aside, is making its own very good case for going lower.
The outlook for next quarter isn’t brilliant either; 72% of those who’ve issued guidance for the fourth quarter have taken expectations lower, with Hurricane Sandy, the eurozone and slowing growth in emerging markets among the causes blamed. Analysts are also, unsurprisingly, becoming less optimistic, doubtless responding to the sorts of noises they are hearing out of the companies they follow.
None of this takes away from the importance of the fiscal cliff, which if we go over it will indeed reduce the amount of money flowing into corporations and, depending on scenario, cut 1% to 3% or so off of economic growth in 2013. Nor, for that matter, can you ignore tax rates.
That said the value of an equity ultimately flows from the profits of the underlying company, and given indications that profitability is already flagging even as economic data seems slightly better, we have fair warning of difficult times ahead. After all, you don’t pay taxes on capital gains and dividends which don’t exist.
Growth or recession in 2013?
Edwards notes that the pattern since 2009 has been for economic growth to rise going into the end of the year. This in part may be a relic of the Lehman-induced collapse in the fourth quarter of 2008, which was so incredibly dire, with growth contracting at a 9% annual rate, that it has led to doubtful but flattering seasonal adjustments ever since. The downside, of course, is that the first quarter has been, in each instance, a disappointment, undermining markets in the process.
This year, though, is not setting up that way. Analysts, apparently ignoring the rosier data, are forecasting fourth-quarter growth coming in at a less than 2% annual rate. If we are getting a milquetoast fourth quarter what will next year look like?
“The recent decline in the equity market is more reflective of the dreadful profits backdrop than the upbeat economic data. The last time we saw this divergence between the market and the data (mid-2008), the economy had already slipped into recession some six months earlier. That is where I believe we are now. As we move into next year, expect the combination of poor profits and poor economic data to prove toxic,” Edwards wrote.
The Federal Reserve, for its part, seems bent on remaining the one solid bulwark underlying the market. The newly released minutes from its October 23–24 policy meeting showed support for launching another Treasury buying program when the existing one expires at the end of the year. The Fed’s current program, called Operation Twist, involves selling short-dated paper and buying long bonds, keeping the size of the portfolio the same but driving down longer-term rates and, hopefully, sparking investment.
It’s important that the Fed keeps the support going, because in some ways, it is the best thing equity markets have. At least it is important from the point of view of equity holders; the long-term impact is far less easy to peg.
For now, we have a solid Fed, a questionable economy, deteriorating earnings, and political and fiscal risk.
(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at jamessaft@jamessaft.com)