Heads I win, tails you lose

david mind sq closeupBy David Nelson, CFA

On the heels of a year most investors would like to forget the first Q4 earnings reports are in with some interesting observations. The most surprising data point this season is the following: Investors are rewarding both positive and negative earnings surprises with higher prices. FactSet data shows companies coming in above estimates have seen their stock price rise an average +1.3% two days after the report. Those that missed, saw an increase of +0.6%. The latter is certainly an indication investors are betting the slowdown is in the rear view mirror and not an indication of what lies ahead.

Those are great odds, almost too good. Heads I win, Tails you lose is the Holy Grail of gambling. It can’t be that easy and of course it isn’t. While I’d love to believe we’re going to power straight back to the highs I’m certain we have challenges ahead. All the usual suspects are in play not the least of which is a Federal Reserve grappling with a $4 Trillion balance sheet to unwind. While the Fed punted on rates the balance sheet is just too large to sweep under the rug.

spx shutdown

I’ll come back to this in a moment but first let’s tackle recent events. The Shutdown along with an endless wave of media hype that this was the end of life as we know it, put investors on the defensive. I guess stocks didn’t get the memo because from the day the shutdown began to its end on Friday, the S&P 500 is up a staggering 10% in just 21 trading days.

Economists are starting to put to weigh in on the effects of the shutdown and what it means to GDP growth. Goldman’s Jan Hatzius has taken down his Q1 estimate 0.4% and added it back to the second quarter. I suspect others to do something similar.

On Friday the President gave in to mounting pressure to reopen the government. I suspect the straw that broke the camel’s back was the brief shutdown of New York’s LaGuardia Airport due to an insufficient number of air traffic controllers. As robust as our system is, the shutdown of a single airport is enough to cause mounting delays across the country, especially one as busy as LGA. A flight from St. Louis to LA could easily be cancelled because the plane making the flight was grounded in New York. It trickles through the system and before you know it thousands of flights are cancelled.

At least for the coming week, investor focus is going to shift back to where it should be. Earnings, earnings and a Fed meeting thrown in for good measure. Three of the biggest companies in the index report this week including Apple (AAPL), Amazon (AMZN) and Microsoft (MSFT). Apple of course delivered a kidney punch right out of the gate with a pre-announcement including a 14% drop in iPhone sales year on year. The stock has since recovered back to the flat line year to date but given its importance to the food chain and an overall barometer of tech spending, Tuesday’s report will be torn apart. Are Apple’s recent troubles company specific and an indication of a saturated smart phone market or just another data point confirming slowing global growth?

We’re still early in the season (22% of companies have reported). FactSet data confirms that 71% have come in above estimates putting it right in line with the 5-year average. However, only 59% have come in above revenue estimates and that’s below the mean. It’s still too early to make broad assumptions and investor sentiment is still trying to recover from a bruising 2018. The Shutdown and a dysfunctional Washington were the disasters du jour but from my vantage point slowing global growth is still the albatross. With 40% of S&P revenue tied to offshore sales it has to be a drag on the top and bottom line of U.S. multi-nationals.

To be fair some companies have specifically mentioned the shutdown as a source of concern.

companies citing shutdown

Sectors showing the most growth year on year include Energy, Industrials and Communication Services. Bringing up the rear are Utilities and Materials showing the biggest decline in earnings growth,

Fed Day

Fed Balance sheet 2019.png

I’ve criticized the Fed for what I believe was a policy mistake pushing the short end of the curve higher than needed during their quest for normalization. In addition, the Balance Sheet unwind that started in October 2017 was a contributing factor to tightening financial conditions. But let’s be clear! The Fed needs to reduce this balance sheet. The only question is; what will be the pace and how far down do we need to take it? The initial goal was to keep the roll off to a maximum of $50 Billion per month. I believe on average the reduction came in at about $35 Billion. According to CNBC December saw a reduction of $34 Billion. This is the end of the experiment. There is nothing in history Chair Powell or the Fed can use as a guide. Just getting it back to 2010 levels suggests another $1.5 Trillion to go. It’s clear $50 Billion per month was more than we could handle but there’s a number that will work and the challenge for the Fed is to find out what that is.

Tuesday’s FOMC meeting may give us some clues as to their current thinking, Consensus estimates place the odds of a hike this month close to zero with most economists believing there’s little chance until at least June. Unless we see something on the inflation front or synchronized global growth returns, I doubt will see another hike for the remainder of the year.