All About E’s


“Fasten your seatbelts, it’s going to be a bumpy night.” – Margo Channing (Bette Davis), in All About Eve

Could Peter Lynch have been right? Is it really about the “E?” Stock prices are supposedly predestined to go up, because it’s the fourth quarter and the central banks will buy bonds. Fundamentals, that’s what investing is about. Now you want to talk about earnings?

Mr. Lynch, to be sure, is no crank or witch-doctor. The legendary fund manager ran Fidelity’s Magellan fund into what was then the biggest fund in the business in the 1980s with a sterling record of outperforming the rest of the stock market. His book “Beating the Street” is still widely read in the investment community, one of its dictums being that “it’s all about the E”, or the earnings component of a stock’s price-earnings ratio (“P/E”).

Since the Fed and the European Central Bank (ECB) took themselves out of the beauty contest last month with promises of unlimited access, the market is now swinging its head back and forth watching the two “E’s” – earnings and Europe. The pull of a slowing economy and imminent negative earnings growth in the third quarter has been downward, but the far sexier counter-pull of yet another European rescue story has been e-lectric.

Before I go further, I will admit that last week wasn’t quite a fair test between the two. On the one hand, the Dow and S&P actually managed to finish the week higher in spite of the Thursday-Friday smackdown that began when Google’s (GOOG) earnings were prematurely released at mid-day on Thursday. That wrecked the composure of a market fixated on a putative Spanish rescue story that had started circulating in the hours before Tuesday’s opening. It was basking in assurances of one sort or another that prices were simply destined to go higher when the Google mishap derailed the train.

Up until then, you might have said that the Union “E” had the advantage. After all, both Intel (INTC) and IBM had laid earnings eggs after the close on Tuesday, yet the markets shook them off and were rising strongly on Thursday when the Google hit the fan. It may partly have been based on optimism that some goody would emerge from the two-day EU meeting, such as more money for Spain and Greece, or at the least, another step forward to having a central bank regulator.

Why so much fuss over a banking regulator, you may well ask. It’s part of either an elaborate dance or punch-and-judy show, depending on your perspective. European finances are a mess, with a ton of bad property loans on bank books. Governments that might once have simply recapitalized them now find it very difficult to manage without their own currency. An EU-wide solution is wanted, but the EU has no federal government. The weaker states have to try to wheedle the money out of the stronger ones. Picture Massachusetts asking Texas for money, and you get an idea of how easy it is. Now imagine Massachusetts wants the money to hire more public servants.

German Chancellor Angela Merkel allowed this summer, in full crisis mode, that EU money could be used to recapitalize banks directly. Not only would that avoid the problem of the beating any EU government would take in the financial markets if it tried to reboot its banks on its own, but as the largest member of the EU, Germany would be putting up the lion’s share of the money. Rally time!

The Germans and Chancellor Merkel, however, are more than a little suspicious about the financial conduct of their partners. They insisted on a banking supervisory agency first, as a kind of financial gatekeeper. The two major EU camps, one led by the French, the other by the Germans, have very different ideas about the agency. The French attitude is, let’s get this agency going as fast as possible and start handing out the money. The German attitude is, let’s make this agency as tough as possible so it gives out the least amount of money. Oh, and by the way, can it wait until after the German elections next fall?

So no presents were forthcoming. The French and their allies want pro-growth spending, the German-led group wants budgetary veto power so the pro-growth spending doesn’t translate into more money for more public employees. Stand-off. The two sides have often managed to come up with some joint communiqué promising a rosy future in the past, and it was thought by many – myself included – that some optimistic double-talk was inevitable.

But as a European analyst pointed out about the EU meeting, “there is no pressure coming from financial markets right now.” Silly me, I should have realized that the EU only acts under pressure. No banking agency, no Spanish bailout (“bailout? who needs a bailout?” said Spanish Prime Minister Rajoy, who is facing regional elections next week. He promised no bailout request during his party’s own electoral campaign). As for Greece, well, everyone is going to sit down and have another think on it. Lots of praise for Greek Prime minister Samaras, but no money before November.

That left the stage to the other “E”, earnings, and those were found wanting. Not only did Intel, IBM, American Express (AXP) and Google disappoint, but then General Electric (GE), Microsoft (MSFT), McDonald’s (MCD), Honeywell (HON) and Parker-Hannifin (PH) all disappointed in one way or another. It’s really quite an impressive list. Only the usual last-minute closing bump from Friday dip-buyers was able to keep two of the three major indices in the green – the Nasdaq and tech just had too much bad mojo, what with Google and Apple (AAPL) both getting terrific pastings.

So where does that leave us? I’m not going to predict what may happen with the Spanish elections, except to say Prime Minister Rajoy appears to be dead set on no bailout request beforehand. Probably not the day after, either. That will leave the stage for a) earnings; b) the Presidential debate; c) the FOMC meeting; and d) whatever surprises come forth. At least Spain is now set up to surprise us to the upside, however unlikely.

When I look at this week’s earnings again, it’s difficult to be hopeful about next week. The Fed’s hand is played out, and it’s unlikely that the presidential debate will sway the markets much. The best hope is that with many of the largest multi-nationals already reporting, the tide might improve a bit with domestic-centered earnings. Last week I said we needed Intel and IBM to stay out of trouble, and they didn’t. Apple better deliver something good, or the earnings “E” is going to be a big problem.

As for the European “E,” Larry Summers made the interesting observation that the EU was handling its mess much like the US had conducted its Vietnamese policy – always doing the minimum to save face and avoid collapse, but never showing any real determination. Consider that the US political and military rulers were consistently united on a goal of prevailing over North Vietnam, but their efforts lacked popular support and ended in abandonment. The EU’s elite appears similarly united, but may also find itself running aground on the same shoals of popular misery – the periphery countries saying no to more misery, and the core saying no to more money.

The Economic Beat

The economic news was dominated by housing and manufacturing. Since the former news was better, it got more attention from the market, so we’ll start there.

September housing starts were the star of the week, with a seasonally-adjusted pop to an 872,000 annual rate, easily besting the pusillanimous estimate of 765,000. The seasonally-adjusted permit rate was up as well, up 11% on the month to an 894,000 rate. It was a decent report, showing impressive year-on-year increases of 35% in starts and 45% in permits. For all that, the reality of it was more than a little overblown.

To begin with, that estimate of 765,000 was more than a little cooked. Starts showed an impressive monthly gain of nearly 10% last September, and it’s not clear why record-low mortgage rates, the FOMC meeting, good jobs data and another warm month should have derived the less-than-1% gain the so-called consensus had dialed up. That’s just rigging the numbers.

In the second place, the report was led by a big jump in multi-family starts, or apartment and condominium buildings. The actual number of single-family starts was in the exact middle of the range it’s been in for the last five months. To gauge the real health of the market, we may have to wait for November data to pull out the effects of a warm fall and the FOMC excitement. The latter may well have pulled in a slug of fence-sitters from both the buying and building camps, but a bit of heavy weather – including some like the stock market saw the last two days – may cool some of the fever.

The existing home sales rate weakened a bit in September, with a result that was tipped off by a decline in pending home sales last month. Sales were still up 11% from September 2011. A high percentage of the sales remains distressed and all-cash; the percentage for both picked up slightly from August. With buy-to-rent now a certified investing craze, it would be interesting to see how much of next week’s new-home sales data represents investors, but there is no such data publicly available.

The homebuilder sentiment index inched up a notch, though it was below consensus for a slightly higher gain. It’s probably fair to say it was really unchanged, due in part to the reality that although permits rose on a seasonally-adjusted basis, they fell in real terms.

Turning to manufacturing, the New York Fed survey led off with a weak report that seemed to presage the earnings of the industrial stalwarts. Shipments were negative for the first time in over a year, with new orders still negative and business conditions given a rating of (-6.2), better than last month but still poor.

Industrial production rose 0.4% in September, a result that was cited in the middle of Tuesday’s Spanish-bailout euphoria as another “surprisingly strong” result, given that the consensus was for a gain of 0.2%. It wasn’t, however. August production was revised down an additional (-0.2%), meaning the four-tenths gain left the index exactly where it was expected to be. Given that Hurricane Isaac took the August numbers down quite a bit, a bigger rebound should have been forthcoming if production were in good conditions. It was led by gains in utility output, which are always lumpy. At this point in the month, it’s hard to see another gain for October.

The Philadelphia Fed survey was positive for the first time in five months, but I treat the result cautiously. To begin with, new orders were still negative while shipments were flat, which isn’t much improvement after five negative months. The “conditions” part of the survey may have improved for reasons based more upon the stock market or presidential debates than actual business, seeing the data for orders and shipments. In addition, it’s a diffusion survey. After five months of down readings, a small positive could mean that activity is still quite subdued. September durable goods are up next Thursday.

I probably don’t need to tell you, but weekly unemployment claims spiked hugely after a similarly dubious decline the week before. Apparently California didn’t hand in all of its data last week. Averaging the two out leaves the same trend intact, so there doesn’t appear to have been any real change. Reporting problems are going around, as Google can attest.

The week began with the retail sales report, which appeared to rise by a robust 1.1% versus the consensus for a gain of 0.7%. But the data really wasn’t as good as it appeared. Gasoline and auto sales are leading the way. Contrary to the thinking that the consumer is back in the game all-in, it may signify instead that there is less disposable income left for other purchases. The weekly chain-store reporting services aren’t showing strength so far through October. The year-on-year growth rates have been declining steadily and are drifting back towards the inflation rate. The McDonald’s and Chipotle (CMG) earnings reports talked about a difficult consumer environment.

The Consumer Price Index reported a gain of 0.6% for the month, with both the core rate (excluding food and energy) and overall rate reporting 2% year-on-year gains. It’ll be interesting to compare that number with the upcoming GDP report, which has a way of using complete outliers for its price index from time to time.

China reported third-quarter GDP of 7.4%, meeting estimates and prompting many eager proclamations that the bottom must now be in. However, some estimated that the Chinese books had been cooked for political reasons, and that the real number was about a percent lower. With Europe’s recession deepening and the US fiscal cliff beckoning, it isn’t clear anyway why the export-based Chinese economy would have put in a bottom, unless one is long emerging-market stocks and desperately needs a bottom to be in.

Next week has the earnings season in full flood. Many of the largest companies have already reported, but Caterpillar (CAT) will report before the open on Monday. The company reported on Friday that its sales have largely declined for three months in a row, so it could get the week off to a rough start. United Technologies (UTX) is on Tuesday.

The economic side of the calendar doesn’t really get going until Wednesday, when new home sales are reported in the morning and the Fed has its FOMC statement in the afternoon. With nothing left to cut in rates and QE-infinity already underway, the market for once isn’t talking about the meeting. An outlook change of sorts could still be good for some volatility, however. Boeing (BA) and AT&T (T) report that morning.

As mentioned above, durable goods comes on Thursday, along with the Chicago Fed National Activity Index, a favorite of economists and wonks. It’s been in steady decline of late. Pending home sales for October are out later in the morning, followed by the Kansas City Fed survey (the Richmond Fed survey is released on Tuesday, though neither are big market-movers).

Notwithstanding the Fed, Friday should be the trading day of the week. That’s because both Amazon (AMZN) and Apple will report earnings after the close on Thursday. Then Friday morning before the open, the Bureau of Economic Analysis will release the initial estimate on third-quarter GDP. Disappointments will be treated severely at this point, as there is no more lure of bringing in new money from the Fed. It’s already in. A consumer sentiment final print from the University of Michigan rounds out the week.

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