The chart above shows the rapidly declining internals within the S&P 500, which in the past has signaled significant declines in the S&P 500. While many big cap stocks continue to hold up, most stocks have begun to struggle.
I will return to this subject below because the starting point in “markets” today should always be context. This means that it has become crucial to first understand the perspective of policy makers as they have become so entangled with “markets”.
A great deal is revealed by the interactions between policy makers and Nomi Prins, when she was invited to speak at the Federal Reserve, IMF and World Bank Conference last month. As a consistent critic of these institutions she was clearly surprised by the invitation and decided to pre-release what she intended to present to check that this was appropriate. Fortunately, there was no problem and the presentation based on the slides below went ahead.
It is great news that policy makers are having discussions to engage in these problems, which are very clearly laid out in this presentation. However, the more one goes into looking at these issues and understanding the dynamics, the more it reveals just how deep these problems have become.
Fortunately, Nomi Prins explains this very clearly in a great interview published this week. As was clear from the BIS report, many in policy circles are now struggling with the realization that central banks have trapped themselves in an artificial financial construct that they themselves created. Now there does not appear to be any good solutions and their options are becoming increasingly limited.
These issues will become ever more acute as their market engineering policies become increasingly challenged. As more and more stocks begin to struggle, as the chart above shows, how will the policy makers keep markets up?
A decisive factor may be earnings, as it will become increasingly difficult to hold up equity markets if earnings turn flat or down. Analyzing Q1 2015 reports shows that this problem may have already begun. Certainly GAAP earnings have shown little to no growth for several years now, judging by both Q4 2014 and Q1 2015 levels. What is also clear is that companies are going to ever greater lengths to boost their non-GAAP earnings. Non-GAAP add backs to GAAP earnings have risen significantly.
Earnings presentation is one approach and, in addition, company share buybacks have also supported stock prices. These boost earnings per share, boost the stock price, and have continued to accelerate. 2015 will be another record year for company buybacks.
For the big caps stocks with strong balance sheets these “techniques” can hold up stock prices for far longer into a downturn than ever before, and zero interest rates provide an additional incentive to manage balance sheets in this way. Even when earnings go into a multi-year depression the decline in stock prices can be very limited. Caterpillar is a prime example of this. Their latest earnings came out this week showing that “second quarter sales dropped by 14% – the worst tumble in two years”. However, by accelerating buybacks they may still hit their earnings number this year as well as continue to minimize the stock price decline.
For the big caps stocks with strong balance sheets this is an attractive option but smaller companies, even within the S&P 500, have much less balance sheet flexibility. Hence the growing divergence shown in the chart above. However, even big cap stocks are increasingly under pressure. World trade volumes have just recently fallen for 5 months in a row. The article below shows that “This is the steepest and longest decline in world trade since the Financial Crisis”.
No wonder the central banks have become so worried. What will they do if earnings continue to weaken at record valuation levels and corporate balance sheet engineering becomes less effective? Without any earnings tailwind will they have to resort to Chinese levels of stock market intervention now being criticized by the IMF? Or since they can no longer cut interest rates, will they have to return with ever more extreme versions of QE, which has proved to provide only a dysfunctional temporary reprieve?
No wonder central banks are worried about how to manage this predicament. Short term actions may make it possible to defer these issues, but where is the longer term strategy?
David Stockman concludes that the central banks have “shot their wad”.