One of the interesting thing about the recent market selloff has been that it’s occurred against a backdrop of seemingly fine economic news.
We noted last night that the decline was happening, even as the Citi Economic Surprise Index was hitting new highs:
Photo: Bloomberg, Business Insider
In his latest note, SocGen’s famously bearish strategist Albert Edwards says there is no mystery going on here.
First he notes that a divorce between stocks and economic surprises is not unprecedented. It happened in… 2008.
But more specifically, Edwards says it’s all about the fade in corporate profits, and the declining change in analyst expectations about corporate profits.
I think the key to understanding the recent breakdown of the equity market lies with profits. We have been emphasising for some time that profits are declining in the US, albeit at a much slower pace than declines seen in the rest of the world (that by the way is solely due to the lack of any fiscal tightening in the US relative to the rest of the developed world.)
In the piece Alberts quotes his own colleague Andrew Lapthorne, who makes an interesting observation about earnings season
“the outlook for earnings has been extremely poor in recent weeks. Yes, the US reporting season led to an improvement in near term (2012) earnings forecasts with the ratio of upgrades to total estimate changes for 2012 earnings rising from 44% to 50% over the past month, but earnings momentum for 2013 has slumped, dropping from 48% to 42%, leading to a major divergence between the two divergence with that of Europe). For earnings momentum to collapse during a reporting season is highly unusual, as optimistic forecasts are generally reeled in over the period between reporting seasons“.
So the bottom line is that EPS optimism really crumbled during earnings season, and actually, if you look on this chart, you can see that it really started its decline early October, basically right when the market peaked, which puts some meat on the bone of this theory.
With some austerity certainly coming (a fact that is expected to hurt corporate profits), and earnings optimism fading, the selloff has logic to it, even against the decent macro backdrop.
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