False Dawn Or False Dusk

Much like watching animals in a zoo, particularly dangerous ones, rangey markets create excitement the closer they get to their boundaries. Last week's excitement in the bull pit has already faded as the beast retreated back into the shadows and today the excitement is in the bear enclosure as equities approach various supports. But TMM are as sanguine as ever towards many of the screams of encouragement.

As far as earnings seasons go, this one has been somewhat disappointing. While earnings have beaten expectations, they have not done so at historical beat rates, revenues have missed and guidance has been rather downbeat. The question, as always, when interpreting such releases is deciding whether (a) the information is new, and therefore forward looking, and (b) what the implications of that news are. So what do we learn from these reports then? Global growth was pretty weak over the quarter - particularly in China and in Europe, CapEx intentions have fallen in the face of electoral and fiscal cliff-associated uncertainty. Well TMM would argue that none of those are particularly ground breaking observations, in the light of the macro data over the summer and the constant barrage of debate around the election and the fiscal cliff. And on the guidance front, it doesn't exactly seem as though corporates know any better than the rest of us, with Caterpillar, for example, forecasting that their earnings over the next year would be in the range +5% to -5%. i.e. - "We'll either make more money... or we'll lose money". Thanks guys, really insightful.

So in our eyes, while bears are excited to seize on disappointing earnings news, TMM reckon these are all a bit backward looking. And there are several reasons why. First, unlike late-2007/early-2008 when earnings news began to worsen, policymakers are no longer behind the curve - cast your mind back to that period, and it was marked by large intra-meeting rate cuts by the Federal Reserve, attempting to catch up with the fast-deteriorating economic data, while the ECB and BoE refused to ease policy due to still worrying about inflation risks. This time around, earnings season has come just a few weeks after the most extraordinary central bank easing measures introduced to date: QE-Infinity and the ECB's OMT. These have had a dramatic effect in easing financial conditions over the past six weeks, the effects of which will not have fed through to the real economy yet - it's just too early. Markets, as forward discounting machines, are likely to concentrate on future earnings, rather than backward-looking ones.

Second, again - unlike late-2007/early-2008 - the economic data has begun to rebound: particularly in the US and Asia, but also in Europe. The bottoming in PMIs, exports in Asia and the reacceleration of China into the New Year are all positive for earnings going forward. Third, it appears to TMM that many are extrapolating the weakness seen in Tech earnings to the broader market, but that masks a rotation that is ongoing and a positive one at that - out of defensives and into cyclicals (See below chart of GS Cyclicals vs. Defensives).

Fourth, the weakness in risk has thus far appeared restricted to equities themselves, as cross-asset correlation has collapsed, as has that of the index itself (see below chart of implied correlation). Add to that the volatility bleed across the board as central bank liquidity suppresses risk premia, and it is hard to get to get too excited about a down trade. That said, as per TMM's last post, we do advocate buying cheap tails for protection.

Fifth, regarding the election and fiscal cliff debate, TMM are of the mind that this is a two stage wall of worry. Once the election is over, that is one hurdle of uncertainty passed, and markets are likely to squeeze higher, no matter who the winner. And secondly, TMM struggle to think of an "issue" that markets have discussed both so much and so early, than the fiscal cliff. The result of that, in TMM's minds, is that the market already discounts a significant probability of going off the cliff, and that even a going over the cliff for a few days until an agreement is made is unlikely to phase markets much beyond a knee-jerk, and certainly not anything like last August's broad de-risking. This is as much a fact of investors not exactly holding a huge amount of risk.

Finally, while last night's late rally was attributed to a spurious article suggesting further FOMC easing, it has been noted by many that there are often mutual fund inflows at the close. And the large nine-week stretch of equity outflows finally came to a close last week. So TMM are of the view that real money is likely to be accumulating length into weakness - and the low volume sell off this morning feels to us as though it is merely HF and CTA activity. Absent major macro news, TMM would argue the old adage applied "don't sell a quiet market". Buy the dip.