The last of the three bodies - Catalysts

The last of the three bodies in the three body problem is Catalysts. 

As we build the view, it is important to know what the trend of the economy, and therefore the trend of the market is. It is important to know what is driving this trend at home and abroad, and how this impacts different parts of the market.  In addition, one must ascertain the behavioral tendencies of the market, to determine where the supply & demand is. Price is the intersection of supply and demand, so discerning what is affecting either of these, is vitally important.  However, in both of these cases, Newton's First Law the law of inertia, will hold. An object in motion will stay in motion unless acted upon by another force. This other force comes from catalysts. 

There may be many that an investor should consider, but I have simplified this into three specific catalysts. Since last week's blog was so long, I wanted to give you a break. The three catalysts I will discuss are economic surprises, earnings surprises, and geopolitical risk. 

First, economic surprises. Our friends at Citi have comprised economic surprise indices for more than 2 decades. These measures do not tell us about the trend of the economy and what is driving that. it does not tell us which economy is stronger than the other. Importantly, it tells us how the economic data that arrives every day and every week of the year, is coming in relative to expectations. Markets move at the margin. Markets will, to some extent, price in the news that the consensus agrees upon. Thus is is only when the news comes in better or worse than expectations that prices will adjust. High absolute growth is good, but if it is not quite as good as everyone hoped, there will be a negative reaction. The fundamental category will capture the high absolute level, the catalysts catch the latter. As I look around the world, I simplify into four areas: US, China, EU and EM. How are data relative to expectations?  On this front, we can see that in China, where the economy has been weak and has been expected to continue to be weak, at the margin, the data have been consistently better for several months.  On the flipside, in the US where the economy is quite strong, the data over the last month or two have begun to disappoint expectations. Not surprisingly, we are starting to see the reactions in the asset markets to these surprises. Optimism will start to creep into China. Doubt will start to creep into the US.

 

The next area is earnings surprises. With a hiking cycle starting it is reasonable to assume that mutiples for stocks will continue to compress from the extremely high levels seen at the end of 2020.This doesn't spell doom for the overall market, however, it does mean that companies will need to continue to deliver on sales & earnings growth in order for their stocks to move higher. Not only growth but growth that is better than expected. Recall from yesterday that markets move at the margin. In order for a stock to move higher not only must growth be high in absolute terms but also must be high relative to expectations.

As a sector,financials have had the most & biggest reporters.The 1st chart today shows the growth metrics in aggregate & across each sector. You can see that across the board (with one exception) we have had double digit sales growth & 20%+ earnings growth. In the lower left of the top chart, while high in absolute terms, the magnitude of this growth is down over the last several quarters because we are lapping some tough comparisons from earnings last yr that were growing over a Covid base. Still quite strong.

The 2nd chart looks at how growth has come in relative to expectations, or the 'surprise' (As an aside, this number is almost always positive, its part of the game). How positive was it?Sales surprises have been about 2% higher & earnings about 9% higher. This is spread pretty consistently across the board with a couple outliers from sectors where only 1 name has reported. If we look to the lower right the reaction to the news has been muted to positive.Like I said, earnings always seem to surprise but we can see in the lower left the surprise % is less than the previous several quarters so the market is unimpressed. .

There are some other headlines & moves we want to consider. The investment banks -JPM, GS, MS- are warning us of higher wages going fwd. The amount the companies are setting aside for compensation is up. P&G spoke about 6% organic growth, with 3% from volume & 3% from prices.The price of what we need to buy is going higher. Inflation appears to be more embedded.Then we have the Covid high fliers coming back to Earth. Peloton is finding that it is actually a fitness company & not a software firm & bikes aren't selling. It once hit $160 but is back to $25 we started pre-Covid.Speaking of inflation, Netflix says it is raising prices again, but that subscriber growth going fwd will be slower. Still double digits, but low double digits. For a stock at over 40x P/E, this was clearly not the right message as it is down 19% pre-market.

Finally, I consider geopolitical risks. With Secretary of State going to Russia to meet in regards to the potential invasion of Ukraine, following on from the 'assistance' Russia is offering in Kazakhstan, there is reason to think that there is heightened geopolitical risk. However, this may be a recency or availability bias instead. In fact, if we look at the long-run time series, this measure of geopolitical risk is not elevated at all. In fact it is in the lower quartile of history.

Of course, as we saw in the mid90s and the early 00s, we can have a sudden spike from low levels. Even going back to WWI you can see a spike from low levels. However, we can see the gradual move to very high levels before WWII and the continuous elevated levels thru the Cold War. So what does this mean?

To me it means that this is an area that the market will not pay attention to barring some unforeseen event. Covid is not going to be that event at this point. Russia, North Korea, Iran? All known knowns. Risky for sure, but not the type of risk that could derail a market.

This particular category is always either a negative or a neutral and never a positive for markets, outside of a period such as win the Wall came down and there was a multi-year peace dividend to the market. In spite of the headlines of unrest around the world, if we look at the news thru this sort of objective lens, we can see that, not only is it just business as usual for the markets, but actually less risk than usual. 

How do we pull it together? From a US perspective, economic data has started to consistently disappoint. Yes, there is better than expected news in China, and we should expect that ahead of the Olympics. Can this persist? The US has been the driving global force economically and so this should give us pause.  Earnings are coming in better than expected, but as I mentioned, they always do. Are they better than the 'whisper'?  Wall Street plays this game, where companies sandbag and analysts keep their estimates too low. Then numbers come in better. However, reading between the lines of analysts reports, one can begin to decipher when we should expect these upside surprises. Thus, the lack of reaction to good news is telling.  Finally, geopolitical risk stands at quite low levels vis a vis history. However, there are a number of potential conflicts in which Russia is involved, that investors need to keep their eyes on.  It is difficult to call this category as a negative until we see more earnings in the next week or so. It is difficult to call it negative until Putin officially screws over NATO. However, it is neutral with the decided risk of something negative occurring in the near term. 

Stay Vigilant