A number of factors are pointing to a developing market top, including a disappointing first quarter earnings outlook, the effects of fiscal restraint, the continued ineffectiveness of Fed policy on the real economy, the crisis in Cyprus and the world-wide recession.
Third and fourth quarter S&P 500 earnings were not only disappointing, but actually down from a year earlier. Historically, two consecutive down quarters have occurred only in recessionary environments. Estimates for the first quarter of this year are up about 5% from a year ago, but have already come down steadily since September.
Now a number of reports indicate that the downturn in estimates for the quarter is starting to accelerate. In just the last two days we have seen downward earnings revisions from either management or analysts for Federal Express, Oracle, Caterpillar, Airgas, Cisco, JDS Uniphase and Guess. With 10 days still remaining in the first quarter, we think these downgrades are harbingers of more significant disappointments ahead.
The negative effects of the fiscal cliff settlement and the sequester have mysteriously been put on the backburner, but will become more evident in the period ahead. It wasn’t until a full 30 minutes into Chairman Bernanke’s press conference that somebody thought to ask about fiscal restraint. Even Bernanke seemed to downplay the problem, answering that it would be “somewhat” negative. In fact the Fed’s GDP projections for 2013 were only 0.2% lower than its prior projection in December. This seems somewhat at odds with his previous testimony before Congress expressing great concern about the Fed’s inability to offset near-term fiscal restraint. The fiscal cliff settlement and the sequester is estimated to subtract about 1.5% from GDP, an amount that is unlikely to be offset by the economy. Furthermore, various estimates indicate that employment could decline by 500,000 to 700,000 from the sequester alone.
As for Fed policy, there is little evidence that QE4 is having any significant effect on the real economy. Bernanke reflected this uncertainty when he acknowledged that the economy seemed to be strengthening in the early part of each of the last three years only to falter after that. He raised the thought that early-year strength may be caused by distorted seasonal adjustments resulting from the recession, an issue we have discussed in past comments.
The Cyprus crisis is another issue that may have long-standing repercussions in the market. We don’t know how this will turn out, and it may well be that it will all be settled by early next week. The key point, however, is that no matter what happens, the EU has cast doubt on deposit guarantees throughout Europe and has called into question whether depositors are certain that their funds are safe. From this point on, the depositors of banks in Spain, Portugal, Greece and Italy will regard their funds at risk, substantially increasing the possibility of either a run on the banks or a slow, but steady withdrawal.
At the same time the global economy continues to deteriorate. Both the German purchasing manufacturer’s index and the Euro-area indexes for services and manufacturing unexpectedly declined with much of Europe already in recession. Industrial commodity prices are declining, including the all-important copper index, possibly reflecting a decrease in Chinese purchases of raw materials. After 23 years of extremely slow growth, Japan is embarking on yet another round of additional stimulus.
In our view, the stock market can look to the two-legged stool of Fed ease and rising earnings for only so long. One leg of the stool----earnings growth---- is already coming off and the Fed’s efforts to raise the real economy are falling short. At this point we believe the risk of a substantial market downturn far outweighs the potential upside reward.