Another Round of Panic
Trading and investing are quite different things, a matter of time frames.
Today’s trading was sparked by the ISM services report, something that has not attracted much attention in recent years. The Market has focused more on the traditional ISM manufacturing survey, partly because it has a longer history, and a clear link to GDP. For those who have forgotten that report, released two trading days ago, it suggested GDP growth of 3% as of mid-January, the time of the survey.
The ISM service release was surrounded by some controversy because of a change in the method of calculation and the early release of the data. The ISM, in circumstances nicely reported by Kelly Evans of the WSJ, admitted in a conference call that information might have leaked, so they announced the result before the opening. We are always amazed to see that people do not realize that big traders can always find a way to play information when regular stock markets are closed. Globex futures trading, anyone?
Significance of the Report
Most market participants realize that the service economy has assumed greater importance in recent years. The large move in the index played into the recession fears of many. As the market declined, this seemed to be confirmation of increasing recession odds.
The market and media reaction was that if many react to a piece of data, it must be right. Let us look a bit deeper into this information. When so many stampede, there may be a contrarian opportunity.
We have tested the ISM service series against employment changes and other economic data, and we find it to be pretty good. When comparing it to the ISM manufacturing index we discovered that it did not add much information. We now have a single data point where there is a significant divergence. This would be nice to test, but there are not many other divergences to use.
Our review of today’s news did not find anyone else who highlighted this statistical fact, or wondered about the meaning. This provides an edge for our readers.
Other Interpretations and Advice
We realize that those with a predisposition to seize upon any evidence of incipient recession are touting today’s number, even if they never mentioned it before. Readers might want to compare the current interpretations from these sources with those from past months when the services figure was stronger than manufacturing. There is a lot of selective perception at work. Pick your favorite source and do a search to find out whether this number was ever highlighted when it was strong.
Briefing.com, an unbiased interpreter of information, reports as follows:
The data seem inconsistent with the harder figures on spending and investment
and world trade which really provide the trends for domestic growth. We also
believe that the intent of this ISM index — to reflect on growth for the entire
economy outside of manufacturing — is a mighty grand objective given the
simplicity of the survey questions.
For each component (e.g. activity, employment, orders), the question to the
survey respondents is simply, "Are conditions stronger, unchanged or weaker than
the prior month?"
Gary D. Smith, who has a strong multi-year record of market forecasting, provides excellent daily commentary on his blog. Unlike some other providers of links, Gary cites information from every possible source. He tells the "whole truth" without any cherry-picking of information. Here is his take:
I continue to see the US Fed as now “ahead of the curve” and the odds of an intermeeting rate cut are rising meaningfully. The VIX is rising 8.0% today to a high 28.0. The ISE Sentiment Index hit a below average 102.0 and the total put/call is hitting an above average 1.12. Finally, the NYSE Arms has been running very high again all day at 2.47, which is also a positive. I
still view the odds of a full retest or new lows in the market as
unlikely and further weakness providing good entry points in favorite
longs for investors.
Read the entire article to get the full context.
The Earnings Mythology
The recession hypothesis is getting an additional boost from commentators who claim that forward earnings are in decline. Briefing.com has some great information on this:
According to Thomson Financial, fourth quarter 2007 earnings are expected to
decline by 20.7%. The main reason for the decline is the financial sector’s
whopping 105% decrease in earnings. If the sector was removed, earnings would
grow by 11.0%. Homebuilders are also a drag. For example, the consumer
discretionary sector’s earnings would grow by 7%, instead of declining by 15%,
if homebuilders were removed from the calculation.
In general, we do not like throwing out the worst or best sectors from the overall S&P 500 earnings. This might be an exception. The last quarter is a bit unusual because of the forced write downs of mortgage securities. Some believe that there are many more write downs to come. We think that the FAS 157 losses might actually overstate the impact on these firms. They voluntarily chose to keep securities on the balance sheet, probably because the expected performance to exceed current value in an illiquid market. The jury is out on that question.
Meanwhile, the rest of the market sectors are not showing mean reversion, recession, or any other sort of earnings decline. For example, Colin Barr’s nice review of the Disney report highlights a good past quarter, and good future prospects. This is a company that one would expect to be hit by consumer distress, if it were already an important factor.
Forward earnings will depend greatly upon how financial stocks rebound from current conditions.
Markets look forward. Even in recessionary times, a fact not yet in evidence, forward earnings look through the recession, setting the stage for rebounds in stocks prices.