U.S. stocks ran into some trouble yesterday, not because the day’s earnings releases disappointed – they largely beat expectations -- but as a result of something much larger to this market: the threat of one element of global-stage super stimulus being removed.  China chose to raise its benchmark lending and deposit rates for the first time since 2007 as they grow increasingly worried about asset and consumer price inflation – a situation we’ve talked about on several occasions over the past several months. 

Also playing a role in the decline was what’s becoming a gathering wave of lawsuits against Bank of America, and it’s unlikely the other banking giants will escape this legal wrath in the weeks to come, over faulty mortgage loan standards; this will force the banks to buy back mortgage bonds from investors, what’s known as “put backs.”  Further, a report from Moody’s showed their commercial property price index fell to an eight-year low (down 43% from the 2007 peak), placing a double whamming on the financial sector. 

Proving that the news out of China had more to do with the sell-off than the mortgage mess was the fact that energy and basic material shares led the broad market lower.   (For those not familiar with the connection, China’s growth, which undoubtedly would not be so strong in this global environment without massive levels of government stimulus, has helped to fuel commodity prices – it’s not all about the Fed and the declining dollar.  Financials were in the middle of the pack.  Utility and consumer staple shares outperformed, but all 10 major industry groups lost ground for the session.   

I’ve got to say though, stocks held up quite well in my opinion considering the potential drag all of these issues can have on growth, which is already at stall speed.

Volume was 13% above the six-month average.

FYI, yesterday marked the 23^rd anniversary of the 1987 crash in which the Dow plunged 22.61% and the S&P 500 slid 20.47%.

Market Activity for October 19, 2010

Pondering China’s Move

China’s massive fiscal and quasi monetary stimulus (not quite the monetary easing we’re used to here in the U.S. as they completely set the lending rates within their state-owned banks – although I must admit it’s becoming more blurred these days) has fueled growth in the entire Pacific region, helped send commodity prices higher, boosted our manufacturing sector via export activity, and propelled growth in economies as far away from the region as Brazil – an economy dependent upon elevated commodity prices.  You take away this super stimulus, which I doubt they’ll ultimately do, and that will get this market very concerned.

(Why won’t they go too far in removing this stimulus, just yet?  In short, Bernanke’s money-pumping actions is already going to result in more capital flooding into China, higher rates over there will encourage more; you’d think this is a good situation to have but not when the Chinese are concerned about asset price inflation and keeping their currency from rising.  As a result, they won’t raise rates too much – this move was only a 25 basis point hike. 

Q3 Earnings Season

Third-quarter earnings season has gotten off to a good start, operating profits up 53% with 16% of S&P 500 members reporting thus far.  Another strong quarter is precisely as expected as year-ago comparisons remain easy – the latest profit cycle didn’t begin to expand until last year’s fourth quarter.  And bank earnings continue to help overall results.  As we’ve talked many times, a large driver of bank earnings has been the release of loan-loss provisions (money that had formerly been set aside due to the largest delinquency rates in the postwar era), and when you release these funds it goes straight to the bottom line.

However, the banking sector has yet to resolve its bad asset problem, a situation that has another round of nasty to it as 4-7 million properties sit in shadow inventory -- the “pig in the python” as the foreclosure process has been delayed several times now.  (And as Risk Analytics’ Chris Whalen recently pointed out, the fate of the largest banks is determined by how Fannie and Freddie deal with their mess; the more loans that the two giant GSEs demand the banks buy back due to sketchy loan approvals the larger the hit to bank earnings.)  The release of these provisions is boosting profits now, but they’ll have to be added back when the next round of excrement hits the fan.

That said, the profit story is not totally boosted by the financial sector, not over the past couple of quarters at least.  Nearly all sectors are posting nice results, but they’re doing so, in most cases, due to the cost cutting from massive payroll slashing – revenues are hardly impressive, which is evident within individual company reports on the whole.  But this operational leverage only gets you so far; without substantial improvement in final demand you don’t get the level of revenue growth that’s sufficient to extend the profit cycle.  Unless final demand arises, which will take meaningful and consistent job growth, the clearing of tax & regulatory uncertainties, and further household debt repair, then the cycle will peter out in the first-half of 2011 – possibly even showing vulnerability by Q4 earnings season.   

At which point, what appears to be a reasonable market P/E of 16 times (usually I would view this as an attractive multiple, but only reasonable in this environment) suddenly becomes 18-20 – too rich for an economy struggling at 1.5%-2.0% growth. 

Housing Starts and Permits

The Commerce Department reported that housing starts (builders breaking ground on new homes) rose 0.3% to 610,000 units at a seasonally-adjusted annual rate (SAAR) in September – beating expectations that had the figure falling 3.0%.  But permits, which is the gauge of construction activity a couple of months out, came in below expectations as they fell 5.6% (expected to rise 0.7%). 

So the current side was stronger and the future side weaker; overall housing construction remains all but floored.  This weak activity is simply the reality of a residential construction market that’s going to have a long slog due to the massive supply issue on the existing home side.  There is a range of 4-7 million properties in shadow inventory, and even at the low end of that range it more than doubles the official number of existing homes available for sale.  Add in that demand for homes is barely off of the floor and you can see why we need a prolonged period of very low construction levels to get this market back to equilibrium. 

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Have a great day!

Brent Vondera, Senior Analyst