Yesterday stocks fell the most in over a month for two specific reasons:
- The US dollar surged to a new eight-month high
- Bad earnings
And, if the dollar continues higher and Q3 earnings (which pick up on Friday with the financials) disappoint, that will jeopardize the S&P 500’s 2016 gains.
So, after a few weeks of relative quiet, we know that some nervous client calls likely started up again for you, because that’s what we’ve been hearing from our subscribers (FAs, Investment Advisors and Portfolio Managers).
Advisors I’ve talked to said the reason for the calls wasn’t because the S&P 500 is threatening to break to multi-month lows.
Instead, it’s because a lot of clients feel that this whole post-Brexit rally isn’t sustainable, and they want to be sure they’ll be able to get out in time, because they don’t want to experience another collapse like we saw in August of 2015 or early 2016.
We all know that client calls like these are usually stressful and uncomfortable.
But subscribers to Advisor Cheat Sheet knew ahead of time what caused stocks to drop yesterday because we told them to be on the lookout for it in Monday’s edition.
In Monday’s Report we said: “If the Dollar Index rises past its July high at 97.62, stocks will take notice, as that will start to pressure earnings (potentially stock negative), so that’s an important resistance level to watch.”
Well, yesterday the Dollar Index surged past that level and stocks dropped accordingly! And any advisor who shared our report with prospects or clients (as many of them do) now looks pretty smart!
What separates Advisor Cheat Sheet from other research reports is that we keep our subscribers focused on the real drivers of markets, not just on what’s in the headlines, and that’s how we prevent our subscribers from getting blindsided by market declines.
While some advisors are avoiding client calls or searching for something to tell nervous clients, our subscribers know what is driving the market and are using this opportunity to show their clients they are in control of the situation.
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Clients want to know whether this is the start of another pullback in stocks, so we’ve included an excerpt from a recent edition of Advisor Cheat Sheet that explains why stocks are threatening to break to multi-month lows, and whether this is the start of another larger pullback.
Bottom Line: Stocks Dropped Because of Earnings
Since Brexit, we’ve said the rally in stocks has been driven by two things:
- First, expectations of $130 2017 S&P 500 EPS.
- Second, a 17X multiple on the market (which was the result of expected forever-low bond yields).
Those two assumptions mean that “fair” value in the S&P 500 is 17 * $130 = 2210.
And, that is why stocks rocketed to that number following Brexit.
But, for the last eight weeks, we’ve been warning paid subscribers that evidence was mounting that bond yields could soon rise, and they have.
As a result, that 17 * $130 = 2200 in the S&P 500 was becoming at best a “cap” on the markets.
And, we’ve been right on that warning as the S&P 500 has stalled at 2200, as pushing the S&P 500 beyond that level simply isn’t reasonable from a valuation standpoint.
Well, now things may be getting worse, because people are starting to reduce their 2017 S&P 500 EPS from $130 down to $127 or even $125.
And, there are two specific reasons for that reduction.
First, the sheer number and prestige of some of the companies negatively pre-announcing Q3 earnings over the past week is surprising.
Specifically, in the last week, HON (down 7%), PPG (down 5%), ILMN (down 25%), AA (down 11% and FAST (down 5%) have all posted surprisingly soft results, and that sample, while small, is a surprisingly diverse group of companies.
Second, and more importantly, the Dollar Index is surging.
Yesterday the Dollar Index surged and broke through that aforementioned resistance level (97.62), hitting an eight-month high. A Dollar Index near 100 is a problem for US corporate earnings, plain and simple, as it will reduce foreign sales. And if the Dollar Index moves towards that number, we will begin to see earnings expectations for 2017 revised even lower.
So, now we are looking at two possible downward influences on stocks:
- First, the market multiple may drop from 17X to 16X as bond yields rise.
- Second, the 2017 earnings expectations may be reduced.
And, it’s not hard to see what kind of effect that can have on stocks:
So, if Q3 earnings don’t stabilize and soon, and bond yields don’t stop rising, then we could be looking at a “worst-case” decline of over 6% in the S&P 500.
Now, to be very clear, I’m not saying the market isn’t trading with a 17X handle right now, nor am I saying I think 2017 EPS are dropping to $125. It’s simply too early to tell whether these trends have legs.
However, both are more likely to happen today than they were last week thanks to disappointing results and a surging dollar, and that’s why stocks are falling.
What This Means for You (and Your Clients)
Step One: You need to watch two key macro indicators
Macro Indicator 1 is 3rd Quarter Earnings. Bank earnings start this Friday and if they disappoint that will spook markets as higher bond yields should help banks this quarter, and right now bank stocks are largely holding the broad market up in the face of higher yields.
Macro Indicator 2 is the 10-year Treasury yield. If it moves quickly towards 2% then that will reduce the multiple on stocks (likely from 17X to 16X) and combined with reduced earnings, a 5% – 10% correction in stocks will be become very possible.
Step Two: Have a Plan to Protect Gains in Place Before the Selling Starts
Yesterday the S&P 500 fell by 1.2%, but most “defensive” sectors didn’t offer any real protection:
- Utilities (XLU) fell more than 1% Tuesday, basically in line with stocks.
- Bonds were flat and didn’t offer any protection (normally they would rise).
- Healthcare plunged more than 2% as bad earnings and macro worries (Clinton presidency) offset defensive benefits.
- But, select sectors did relatively outperform.Specifically, our preferred bank ETF, Financials ETF and Consumer Staples ETF all relatively outperformed the S&P 500.
My point: This higher-rate/dollar-driven selloff could be different than previous declines and just getting into “defensive” sectors might not protect client portfolios for the rest of 2016.
More broadly, if we are going to see earnings, rising bond yields or a surging dollar cause a correction in stocks, it will be important to have a good general hedge that can protect clients 2016 gains.
This reinforces the broader point we’ve been making to subscribers that you have to be tactical with your sector selection in the fourth quarter, or you risk underperforming and finishing 2016 negative.
Just holding “income” oriented stocks through a decline isn’t going to work this time if bond yields are rising!
Our paid subscribers will receive an updated version of our “Higher Rate Portfolio” of tactical investment ideas that can:
1) Protect client portfolios if both stocks and bonds drop, and
2) Identify specific sectors that can outperform in that difficult environment.
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