Jefferies global head of equity strategy Sean Darby warns in his latest note to clients that a key change in the underlying fundamentals of the stock market rally is going unnoticed amid all of the talk about QE3 and the U.S. elections.Darby writes that “corporate earnings are now forecast to drop in 3Q after consecutive quarterly gains since the 2008 financial crisis.”
From the note:
While the markets will continue to fret over Europe’s sovereign destiny and the US Presidential elections, the US profit cycle appears to be finally turning. Last quarter, the slew of earnings downgrades ahead of the results season was so well flagged that markets rose during the announcements. This time round, the deterioration in aggregate profits will be much more transparent.
Darby goes on to compare the current stock market environment to that directly preceding the financial crisis in 2008, saying that there are some “subtle similarities” between the two:
Ironically, there are some subtle similarities of the recent equity rise to the 2006-08 stock rally. At that time, the global economy was booming, but conditions within the US housing market were deteriorating with physical prices falling and spreads on subprime widening. It took nearly a year for the infection from the housing market to spread to the real economy through a widening of interbank and corporate bond spreads.
Today, the housing market is improving, but the global economy is slowing. However, credit spreads have tightened as the Federal Reserve’s QE policies have forced institutions and investors to acquire yield. Hence, a turning point for equity investors under the current monetary conditions is likely to occur when revisions to corporate ratings swings sharply negative.
In other words, investors have flocked to corporate debt as yield has been squeezed out of every corner of fixed income markets due to the low interest rates that have dominated the financial landscape since the crisis.
Now that corporate profits appear set to fall in the next earnings season, investors should be on the lookout for negative changes in corporate credit ratings.
Darby thinks when these downward revisions start to accelerate, it will be the signal for equity investors that it’s time to get out of the market.