Watch Out for Lower US Corporate Earnings

In the end, the Fed disappointed. While Operation Twist was extended, no QE3 was announced. And that’s what the markets had expected. So sure enough, risk assets sold off. Surprisingly, stocks did not sell off all that much, at least not yet. The S&P ended the week down almost 0.6%. Volume rose. But volatility did not; the VIX fell slightly, suggesting that growing complacency among investors and traders.

The conventional wisdom is that the markets simply hadn’t fallen far enough for the Fed to have enough political cover to launch another round of quantitative easing. Therefore, therefore there’s no need to panic, because as soon as things get worse, then—surely—the Fed will come to the rescue. Surely.

The macro data in the US continues to deteriorate. It’s getting so bad that it wouldn’t be surprising if the NBER, 6 to 12 months from now, declared that a recession had started in the second quarter of 2012. Specifically, housing starts fell; they were supposed to rise. Initial jobless claims rose….again….this time to just under 390,000. Existing home sales disappointed. And the Philly Fed survey missed badly.

Meanwhile, overseas, Europe is still stuck in recession, with Germany being the last of the strong leaders to succumb. India is sinking. China is struggling, and new revelations are suggesting that actual economic activity is far lower than what’s been officially reported. Brazil is slowing rapidly. As the price of oil collapses, so does Russia’s economy. And anyone else supplying China—think Australia and Canada—with raw materials is also showing signs of weakness.

But US stock prices have been holding up, remarkably. While the rest of the world is down 15%-30% from most recent peaks, the US stock market is off only about 5% from its April highs.

So the question is can this relative out-performance continue?

Well not if US corporate earnings start to break down. And that’s exactly what’s been happening. According to Goldman Sachs, a wave of negative earnings pre-announcements has been sweeping across the market. While the reasons for the lowered guidance varies, the spectrum of firms slashing forecasts is broad. The firms include: Proctor & Gamble, Texas Instruments, FedEx, Bed Bath & Beyond, Nucor, Ryder Systems, Adobe and Starbucks.

The bottom line is this—unless P/E multiples suddenly start expanding (and they’ve been contracting roughly for about 10 years now), then stock prices and the overall market is looking like it’s headed for a more meaningful correction.

Which of course, brings up our friends at the Fed. For as soon as any meaningful correction materializes, then—and only then—can we count on the Fed to act more forcefully, with QE3 or some other scheme whereby it prints new money and injects it into the risk asset markets (if history is any guide, then most of this new money will not flow to the general economy and Main Street), pumping stock prices right back up to where they were, or better yet, even higher.

Main Street will keep suffering. Wall Street will cheer.

Winning!

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