Last Week's Stock Market Decline Portends Poorly for Earnings Season

By Jon D. Markman

Last week's stock market decline was largely the product of geopolitical events ranging from the debt-ceiling impasse and rating agency warnings to new Italian and Greek sovereign debt troubles.

But what's really scary is that a weak week for stocks may well carry into the bulk of earnings season, which comes up next week when 40% of the market capitalization of the Standard & Poor's 500 Index reports second-quarter results.

The S&P 500 fell 3.3% over the course of the week, weighed down by 5% loss in financials.

And beneath the surface, the gains were not that impressive even on the best day of the week, as breadth was just slightly positive on Friday and only 111 stocks across the three major exchanges jumped out to new one-year highs.

Economic data was not supportive of any gains during the week, leading Goldman Sachs Group Inc. (NYSE: GS) to reportedly to lower its forecast for second- and third-quarter gross domestic product (GDP) growth to less than 1.5% and 2.5%, which is dangerously close to stall speed.

The only really impressive earnings report came from Google Inc. (Nasdaq: GOOG), which said it earned $8.74 per share in the second quarter, more than the $7.85 that Wall Street had anticipated, after special items.

The report was pretty clean. The company reported that Google-owned site revenues jumped 39% year-over-year, while partner sites generated sales growth of 20%. Shares jumped 12%, their biggest move in a year.

Over in merger-land, the big news of the week came from Aussie materials conglomerate BHP Billiton Ltd. (NYSE ADR: BHP), which made a bid for U.S. gas producer Petrohawk Energy Corp. (NYSE: HK), while The Clorox Co. (NYSE: CLX) investors cleaned up with an acquisition bid by activist investor Carl Icahn. These bids are arriving because stocks are cheap and companies and private funds are flush with cheap money.

With all that good news you would think the market would have been able to shake off its blues but there were a lot of economic data points that weighed down the mood. The news Friday alone was emblematic.

Industrial production was up 0.2% in June, which was a disappointment to the consensus looking for 0.3% or more. Worse was that May's already crummy 0.1% increase was revised away to reflect a 0.1%, while April's flat reading also was revised downward to reflect a 0.1% drop.

The culprit: Expectations of a big boost in June in the U.S. arms of Toyota Motor Corp. (NYSE ADR: TM) and Honda Motor Co. (NYSE ADR: HMC) skidded into the ditch. Production of motor vehicles and parts sank 2% last month, the third decline in a row. Excluding the motor vehicles and parts industry, analysts noted that production did manage a 0.3% gain.

Manufacturing overall managed a 0.1% gain, the most in three months, even as hours worked in the sector fell.

BMO Financial Group analysts pointed out the unsettling news that production of business equipment (one of the two "bright spots" that Federal Reserve Chairman Ben Bernanke pointed out in his Congressional testimony last week) fell 0.7%, the third drop in the past four months.



Companies are likely waiting to see if employment improves and the debt talks are resolved.

Overall industrial production in the three months through June gained for the eighth consecutive quarter, but the 0.2% rise in the period was the weakest in that stretch.

Now let's talk about people's feelings.

The University of Michigan Consumer Sentiment Index dropped 7.7 points in early July to the lowest level since March 2009. That was the depth of the bear market!

With all the talk about the U.S. government defaulting on its debt (an inconceivable concept) and the possibility of Americans not receiving Social Security or Veterans' checks, it's no wonder people's emotions are in the dumps.

Island Reversal

We all know that debt ceiling debate is a high-stakes game of chicken, as there is virtually no way the two sides will blow up the nation's AAA credit rating over a measly couple of trillion dollars. Yet this unseemly mess is undermining European and Asian creditors' view of the seriousness of the U.S. political process, and will likely lead to a continuation of Friday's equity sell-off on Monday.

Breadth has been the hallmark of the recent advance, but it was terrible the past two weeks, with losers outpacing gainers by a four-to-one margin. Just 140 stocks made new highs in the three major U.S. exchanges on Friday, a low for the past three weeks.



Worse, when you look back at the sequence of trading the past two weeks, you can see a rare "island reversal" in the chart of the exchange traded fund representing the Dow Jones Industrial Average, as shown above.

An island reversal occurs when a market or stock gaps up on what is believed to be good news one day, only to gap down the next day either on subsequent bad news or profit taking. The key identifier is that, in a three-day sequence, there is no overlap in the pricing on Day 2 with Day 1 or Day 3. A lot of the most long-lasting tops start this way. Island reversals tend to be rally killers. But it does not always have to be that way, and bulls will still have an opportunity to recover if they act quickly.

Jason Goepfert reports that this pattern is extremely rare in major indexes: The S&P 500 has shown it just three other times. You can't tell much from three instances. But if you look at island reversals in the components of the S&P 500, it has occurred 592 times in the past 15 years. It led to a positive return the next day in only 47% of the cases, a higher price 50% in the next three days, but a month later prices were lower in the majority of cases.

If you stipulate that the stocks had to be within 2% of their 52-week high during the island reversal, then forward returns become more negative.

This may sound like technical mumbo-jumbo, but what it really represents is investor psychology. It helps answer the question: What do investors tend to do when they receive an upside surprise stimulus followed by a downside surprise stimulus when they are already predisposed toward optimism? The answer is that, over the next month at least, the negative stimulus tends to leave a mental and emotional bruise that shows up in price charts as a decline.

How could fortunes switch so quickly from the surge of the first week of the month?

There is a lot of posturing going on in politics right now that investors are picking up on, and they are translating them into a murkier view on earnings prospects. Few moves in the market or politics are ever what they appear to be on the surface in real time, and the pronouncements we see in the media by political leaders may be a cover for what is really going on behind the scenes.

Basically I think there is an increasing lack of trust between major investors and the political process. I realize that has been going on since the dawn of time. But there is an extra edge lately.

Peering Through the Politics

At the risk of sounding like a conspiracy theorist, the evidence shows that President Obama and Fed Chairman Bernanke have proven to be ready to manipulate markets for purposes they apparently believe are for the public good but may also provide political benefits. I'm not complaining about this mind you, I'm just stating the facts.

Just for recent touch points, consider the sudden increase in margin requirements for silver a couple of months ago, the sudden release of crude oil from strategic reserves last month (which helped set the bottom of the market in late June) or last year's sudden quantitative easing and super-low interest rates. All were personal, major efforts by officials to influence market behavior in profound ways.

Now speed forward to the present. June's unemployment rate came in much, much lower than independent analysts' expectations. Why? Well, business cycle expert Lakshman Achuthan has told us that employment is in cyclical decline. But from a practical standpoint, my guess is that some levers were thrown in the calculation of the jobless calculation.

There's a lot that can be done with seasonal adjustments and other factors much more hidden, and Bureau of Labor Statistics managers in charge of data crunching are political appointees. Also, as for the unemployment rate, which is derived from the household data series, my understanding is that until recently it was calculated off a two-year average of employment. I gather the BLS has recently moved to a five-year average. At the tail end of that period, 2006-2007, employment was peaking.

The reason the administration would do this: If you are running for office next year, it does not matter how bad the unemployment rate is in2011. It matters what the employment rate is in the summer of 2012. And so what is an unemployment "rate" anyway? It is a percentage of something. That means the denominator, or the number that you are basing the rate on, matters a lot.

Five years ago, employment was relatively high. But a year later, employment was faltering. So next year, during the election cycle, the denominator for the unemployment rate will be lower -- which means that even if absolute employment numbers remain static, theratewill automatically decline because those numbers will be measured against a lower number in the past. In other words, the unemployment rate could fall to 7% or 8% ahead of the election even if there is no improvement in jobs.

We can't be sure that this is what the BLS had in mind, or whether it was politically influenced. But trust me on this: officials can and will manipulate the data and try to fool the markets in this way.

The bottom line is that the government has a good reason for making unemployment seem high now so that it can make it look lower during the election cycle. This is something that occurred during the Bush Administration as well, but it's being done with more sophistication now. As a result, markets will adjust both to the lower numbers and to the eroding trust in reported data.

From the market perspective, we now have a standoff, the bulls and bears looking at each other over the barricades with a gleam in their eyes -- each believing that they have the wherewithal to take down the other.

I would love to be optimistic, but that data that I see suggests the world has entered into a cyclical industrial slowdown that has crippled business confidence and job growth. So even if second-quarter earnings are good, corporate outlooks will be poor. And ultimately that means stock prices will peak.

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The Eurozone’s Last Stand

by Nouriel Roubini

The eurozone crisis is reaching its climax. Greece is insolvent. Portugal and Ireland have recently seen their bonds downgraded to junk status. Spain could still lose market access as political uncertainty adds to its fiscal and financial woes. Financial pressure on Italy is now mounting.

By 2012, Greek public debt will be above 160% of GDP and rising. Alternatives to a debt restructuring are fast disappearing. A full-blown official bailout of Greece’s public sector (by the International Monetary Fund, the European Central Bank, and the European Financial Stability Facility) would be the mother of all moral-hazard plays: extremely expensive and politically near-impossible, owing to resistance from core eurozone voters – starting with the Germans.

Meanwhile, the current French proposal of a voluntary rollover by banks is flopping, as it would impose prohibitively high interest rates on the Greeks. Likewise, debt buybacks would be a massive waste of official resources, as the residual value of the debt increases as it is bought, benefiting creditors far more than the sovereign debtor.

So the only realistic and sensible solution is an orderly and market-oriented – but coercive – restructuring of the entire Greek public debt. But how can debt relief be achieved for the sovereign without imposing massive losses on Greek banks and foreign banks holding Greek bonds?

The answer is to emulate the response to sovereign-debt crises in Uruguay, Pakistan, Ukraine, and many other emerging-market economies, where orderly exchange of old debt for new debt had three features: an identical face value (so-called “par” bonds); a long maturity (20-30 years); and interest set well below the currently unsustainable market rates – and close to or below the original coupon.

Even if the face value of the Greek debt were not reduced, a maturity extension would still provide massive debt relief – on a present-value basis – to Greece as a euro of debt owed 30 years from now is worth much less today than the same euro owed a year from now. Moreover, a maturity extension resolves rollover risk for the coming decades.

The advantage of a par bond is that Greece’s creditors – banks, insurance companies, and pension funds – would be able and allowed to continue valuing their Greek bonds at 100 cents on the euro, thereby avoiding massive losses on their balance sheets. That, in turn, would sharply contain the risk of financial contagion.

Rating agencies would consider this debt exchange a “credit event,” but only for a very short period – a matter of a few weeks. Consider Uruguay, whose rating was downgraded to “selective default” for two weeks while the exchange was occurring, and then was upgraded (though not to investment grade) when, thanks to the exchange’s success, its public debt became more sustainable. The ECB and creditor banks can live for two or three weeks with a temporary downgrade of Greece’s debt.

Moreover, there would be few holdouts that refuse to participate in the exchange. Previous experience suggests that most hold-to-maturity investors would accept a par bond, while most mark-to-market investors would accept a discount bond with a higher coupon (that is, a bond with a lower face value) – an alternative that could be offered (and has been in the past) to such investors.

At the same time, the best way to contain financial contagion would be to implement a pan-European plan to recapitalize eurozone banks. This implies using official resources like the EFSF not to backstop an insolvent Greece, but to recapitalize the country’s banks – and those in Ireland, Spain, Portugal, Italy, and even Germany and Belgium that need more capital. In the meantime, the ECB must continue to provide unlimited resources to banks under liquidity stress.

To reduce the risk of financial pressures on Italy and Spain, both countries need to press ahead with fiscal austerity and structural reforms. Moreover, their debt could be ring-fenced with a larger package of EFSF resources and/or with the issuance of Eurobonds – a further step towards European fiscal integration.

Finally, the eurozone needs policies to restart economic growth on its periphery. Without growth, any austerity and reform will deliver only social unrest and the constant threat of a political backlash, without restoring debt sustainability. To revive growth, the ECB needs to stop raising interest rates and reverse course. The eurozone should also pursue a policy – partially via looser monetary policy – that weakens the value of the euro significantly and restores the periphery’s competitiveness. And Germany should delay its austerity plan, as the last thing that the eurozone needs is a massive fiscal drag.

The eurozone’s current muddle-through approach is an unstable disequilibrium: kicking the can down the road, and throwing good money after bad, will not work. Either the eurozone moves toward a different equilibrium – greater economic, fiscal, and political integration, with policies that restore growth and competitiveness, including orderly debt restructurings and a weaker euro – or it will end up with disorderly defaults, banking crises, and eventually a break-up of the monetary union.

The status quo is no longer sustainable. Only a comprehensive strategy can rescue the eurozone now.

Nouriel Roubini is Chairman of Roubini Global Economics (www.roubini.com), a professor at the Stern School of Business at NYU, and co-author of Crisis Economics.

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Halliburton 2Q earns grow 54 percent

By CHRIS KAHN

Halliburton Co. says the expansion of oil and natural gas drilling in North America helped boosted company earnings by nearly 54 percent in the second quarter. Revenue also hit a company record for the period.

The Houston oil services company on Monday reported earnings of $739 million, or 80 cents per share, for the three months ended June 30. That compares with $480 million, or 53 cents per share, for the same part of 2010. Revenue increased 35.2 percent to $5.94 billion.

The results beat Wall Street earnings expectations of 73 cents per share on revenue of $5.64 billion, according to FactSet.

CEO Dave Lesar says that growing energy demand around the world will continue to drive Halliburton's business.

Halliburton's report kicks off earnings season for the oil industry.

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Time to Short the Euro?

by SmartMoney

With Europe's debt woes mounting, some savvy currency investors are shorting the euro against the dollar -- a bold bet considering the greenback's own shaky status.

After months of battering, Europe's economy may receive yet another jolt of bad news on Friday: The European Union's banking regulator is scheduled to release the results of bank "stress tests," aimed at showing which banks have enough cash to withstand another crisis. About 12 to 15 banks are expected to fail the tests, but any additional failures are likely to fuel doubts about the euro, says Brian Dolan, the chief currency strategist for Forex.com. Retail currency traders at forex brokerage firm FXCM had been largely betting on the euro against the dollar until this morning, when they flipped to being net short the euro, says David Song, a currency analyst for the firm's daily commentary site, DailyFX.com. 

The stress tests are only the latest in a long series of tests for the euro. The region's sovereign debt crisis has been unfolding for more than a year, with both Greece and Ireland receiving bailouts and rising fears that Spain and Italy will soon need them, too. On Thursday, an Italian bond auction saw yields on the country's five- and 15-year bonds hit three-year highs, indicating growing concern about sovereign debt that extends beyond Greece. The euro fell to a seven-week low this week, but is still up 6% for the year over the struggling U.S. dollar.

To short the euro, investors with a foreign-exchange trading accounts could simply sell the euro against the dollar leading into Friday's announcement. "More people are coming around to the view that Greece has to default," says Andrew Busch, a global currency strategist for BMO Capital Markets. "That's why I want to continue to try to sell euros on rallies," Busch says. Keep in mind that currency trades use leverage, and that currency markets move quickly and significant moves can appear small to new traders. For example, at the maximum 50-to-1 leverage offered by U.S. forex dealers, a typical trader could be making or losing thousands of dollars on one-cent moves in exchange rates. For his part, Busch recommends taking profits after about a 4-cent slide and setting a stop-loss to exit the trade after about a 1-cent rise in the euro.

Investors without forex accounts can use a currency exchange-traded fund like the Pro-Shares Ultra Short Euro (EUO: 17.56, -0.03, -0.17%) or the Market Vectors Double Short Euro (DRR: 39.25, 0.04, 0.10%). Experts caution: These are leveraged ETFs that track daily moves in the currency, so they also can generate significant losses or gains on seemingly small moves. For example, the Market Vectors product should rise 2% for every 1-cent drop in the price of the euro against the dollar.

Despite the significant troubles facing the euro zone, betting against the currency is far from a sure thing. The fact that retail traders have started shorting the euro is actually a contrarian indicator that might suggest the euro is due for another rally, Song says. Some pros also warn against betting on the dollar, considering the U.S.'s escalating troubles, including the fast-approaching deadline for raising the debt ceiling and signals that the Federal Reserve won't raise interest rates any time soon, Dolan says. That's creating something of a see-saw between the dollar and the euro, as fresh bad news hits one currency or the other in turn, Busch says. "It's what I'd call dueling debt banjos," he says. The third, and perhaps safest option, say some traders: The yen. "Given the uncertainty in this environment it's probably better to be selling risk," Dolan says, meaning selling currencies that fall when investors get nervous, like the Australian or New Zealand dollars, or the iffy euro, versus the relatively safer yen.

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Also in Italy we will see riots in the square?

U.S. Economy: R.I.P. Deflation

By EconMatters

Despite a big 4.4% drop off from energy prices in June following a 1.0% fall in May, the latest BLS data showed that the Consumer Price Index (CPI) for June was still up 3.6% year-over-year.

The core CPI (less food and energy), an inflation gauge watched closely by the Federal Reserve, also increased 1.6% year-over-year, and has been steadily rising and most of the increase has come within the past six months. (See Charts Below)

What's more telling is that the CPI numbers would have been a lot more intense without the 4.4% drop in energy. Notably also, the core CPI is closing in on Fed's long-run overall core inflation target of 1.7% to 2%. Beneath the main number, the CPI for food was up 3.7%, and the index for food at home has jumped 4.7% over the last 12 months, with all the major groups increasing 3.2% or more, while the energy index spiked 20.1%.

Inflationary pressure is also building up in Producer Price Index (PPI). Compared to a year earlier, producer prices were up 7.0% while the core rose 2.4%, the largest increase since July 2009 (See Chart Below). This is after taking into account that gasoline prices slumped 4.7%, while residential electric power costs declined a record 2%.

There is typically a time lag before the cost increases could work through the supply chain from producers to consumers, depending on the type of goods. By looking at the two charts comparing CPI and PPI on all items and core (excluding the more volatile food and energy), one thing worth noting is that in the past twenty years, based a 12-month percentage change, CPI (all items, as well as core) historically had outpaced PPI until around 2003-2005 time frame.

However, since 2008, the more definitive trend has been that producer prices running much higher than consumer prices, yet we haven't really seen a corresponding CPI jump yet in the past two years. In fact, the subdued consumer inflation prompted a wide-spread deflation scare even among the Federal Reserve members and was cited as one of the supporting factors for QE2.

But theoretically, the two indexes should connect where rising prices at the producer level will eventually be passed through to consumers or producers’ profits would suffer with rising input costs.

In an interview with The Atlantic, Barry Bosworth at Brookings Institution noted CPI and PPI baskets have different weights on different items in the index. Services have a heavier weight in CPI than in PPI, thus price changes in goods affect PPI more. So the recent commodity price spikes going into goods have caused PPI to rise a lot more than CPI.

Furthermore, Bosworth pointed out that CPI also tracks housing, which is still stuck in the deep down cycle, whereas PPI does not track housing. This difference deflates CPI compared to PPI.

Ultimately, this means consumers are experiencing the prices on day-to-day consumer staple goods at much higher escalation than the CPI implies, and that producers eventually must either increase their prices to account for the rising input costs or tighten their belts to weather the low profitability. (Based on a recent mall expedition, the latter seems to be the case, at least for the clothing retail sector.)

Some, including the Fed, argue that since materials now account for a much smaller portion of the goods producing cost structure than in the past, as a result, the input cost inflation at the producers is unlikely to show up at the consumer level.

In other words, the Fed is counting on the stagnant wage, contained by the current high unemployment rate, to offset the rampant material price inflation partly fueled by QE2.

The services part of the overall cost structure will ultimately need to rise up to meet (at least reasonably) the actual rate of inflation, and the cost of living, or there will be a whole new set of social and economic troubles worse than the current 9.2% unemployment would entail.

Commodities have been on a tear ever since Bernanke’s Jackson Hole speech building up inflation expectation before the actual QE2 program even started. We caught a glimpse of the redux on Wed. July 13 when the Fed Chairman stunned the world in his testimony to the U.S. Congress that the central bank is ready for the next round of stimulus if the economy continues to weaken.

Crude oil shot up about $1.50 a barrel immediately after Bernanke’s QE3 talk which just goes to show the connection between inflation expectation and Fed’s quantitative easing. That might be one of the reasons for Bernanke’s follow-up qualifying statement that there’s no immediate plan for a third round of quantitative easing.

In the next year or two, it looks like there could be two scenarios emerging:

1. A new global crisis, for example, the U.S. fails to raise the debt ceiling, a wider-than-expected euro debt contagion, or a collapse of the euro.
2. Economic recovery really takes hold in the coming quarters with good jobs and GDP numbers.

For now the odds seem better for the first scenario. Nevertheless, either way, inflation and inflation expectation would only be shooting north. And this latest set of BLS inflation numbers seems to indicate the actual catch-up and pass-through of higher input costs from the producer to the consumer side is already taking shape.

Fed Chairman Bernanke told Congress that central bank officials anticipate that the recent rise in inflation appears likely to be transitory, where in fact the only 'transitory' effects are the QE3 euphoria and the once prevalent "deflation alarm".

Fed’s QE2 brought excessive liquidity on Wall Street that should have gone to the Main Street, which not only has weakened the dollar, dimished consumers' purchasing power, but also has artificially inflated asset prices. The damage to the economy far outweights the benefit of propping up the stock market that not even a Strategic Petroleum Reserve sale by the IEA could mitigate the inflationary effect of QE2.

The recent economic, employment indicators and consumer sentiment basically have given QE2 an "F" on the report card. So learning form the past two rounds of QE, unless Brent crude oil comes down to the high $70's to low $80’s a barrel range, and a more effective implementation and distribution system where the money would go to stimulate the real economy, QE3 should never even have been brought up in any kind of monetary policy discussion.

Of course, I'm speaking on the basis of financial common sense and logic, which may or may not be the course the Fed and Washington would take.

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