Earnings come home to roost

Stocks ended the week on a positive note in the wake of a mildly good inflation figure. Mild was good enough for a strong week for stocks in the wake of last years’ painful performance.

The next shoe. We have made it through a lot together. It’s the first trading day after a long weekend, so I will not go over every painful detail of the last several years. I will try (with an emphasis on “try”) to keep it high level. Let us begin after the main thrust of the pandemic. You know what came next. First inflation, which was bad and scary enough. Then came really bad inflation, but not before the Fed, a long-time friend of all capital markets, not only removed its famed Fed put, but also slammed on the brakes with both feet. The Fed was no longer a friend to the markets adding a level of discomfort not witnessed… well, since the 1980s. It is not that the Fed wanted to see equity markets fall nearly -20%... sorry, nearly -33% if you were a heavy growth investor (those are last year’s returns for the S&P and Nasdaq). The Fed DID want to slow the economy down and the markets should, in theory at least, reflect economic conditions. A slower economy means less profits and lower stock valuations. Higher interest rates also lead to lower profits and along with that, lower stock valuations. Higher interest rates mean higher bond yields which lead to lower bond prices. SO, if you owned any of those, you lost money last year. That wasn’t great. But on that note, the Fed, we ended the year with some positive news. The Fed appeared less angry. Yes, less angry, but still irritated. The Fed expressed its improved mood in a +50 basis-point rate hike in the place of the 4 successive +75 basis-point bumps that came prior. Ok, that was something to celebrate, kind of like wearing short pants in early April when we get the first sunny day at 52 degrees (that’s 10 degrees Celsius for my non-American readers). The markets continued to celebrate after we rung in the new year. The budding optimism was supported by a very-slightly slowing employment figure and a hoped-for, lower CPI release. Two things that should appease the brake-mashing Fed. How far should that take us?

Let us assume that the Fed takes a step back as predicted by the futures markets. That would mean another few relatively small rate hikes which would ultimately lead to rate cuts in the second half of the year. The Fed, in that case, would no longer draw the ire of the markets. Does that mean that the cuffs are off? Nope, not at all. The second shoe has yet to fall, and how hard it falls will depend on how well companies manage their way through the next, at least, 2 quarters. Remember earlier in this note how I referenced less profits? Well, we have seen a hint of those in the third quarter of last year but slowing profit growth was only minimal. Earnings season for Q4 will shift into gear this week and continue for the next several weeks, and what we hear in those releases will, indeed, determine the path of equity markets for the next several months. Most companies beat analyst estimates, so we will have to focus on some other less-reported factors.

Margins will be a big one to watch for. When sales slump, companies typically cut expenses to maintain margins. In last quarter’s earnings we heard a lot about cost cutting measures and must assume that those continued and will continue, but we have to accept that the easy cost cutting measures have already been undertaken. In other words, some companies will start to experience margin compression, which is a fancy way of saying that companies may be less profitable than in the past. Those margin numbers will be the focus of the analyst community in this upcoming earnings season.

Also high on the list will be sales/revenues, but not just whether or not they beat estimates, but rather their quarter over quarter growth. Will sales growth slow as a result of less consumer demand? Have higher prices, higher interest rates, diminished savings, and recession fears cause consumers to take a chill? That would certainly please the Fed, but it may not please some stockholders who expect their portfolio companies to continue to grow sales and earnings. Of particular focus will be retailers, who are really on the front line of consumer inflation. Tomorrow we will get December’s Retail Sales figures from the US Census Bureau. Economists are expecting a decline for a second month in a row. The release may be a prelude to what we can expect from retailers’ earnings. They announce later in earnings season, late February to early March. Companies will also be under pressure to lower prices in order to maintain consumer demand. We will hear about that in announcements from consumer discretionary companies. We have already heard that Tesla recently cut vehicle costs of some models by as much as -20%! That is a sign that demand may be slowing down. It has also been reported that vehicle delivery wait times have dropped significantly reflecting increased supply. You may have missed it earlier, but yes, I did write “lower prices”. Lower demand and higher supply are exactly what causes inflation to diminish. I will say it again to underscore its importance: the Fed may be pleased with those announcements but the stock market, maybe not so much. Pay attention, it’s time to get to work.

FRIDAY’S MARKETS

Stocks ended the week on a positive note, racking up a second straight week of gains, as positive sentiment on inflation and the Fed kept indexes in the green. The S&P500 rose by +0.40%, the Dow Jones Industrial Average climbed by +0.33%, the Nasdaq Composite Index traded higher by +0.71%, and the Russell 2000 Index advanced by +0.58%. Bonds slipped and 10-year Treasury Note yields rose by +6 basis points to 3.50%. Cryptos gained +1.11% and Bitcoin continued its climb, adding +5.22%.

NEXT UP

• Empire Manufacturing (January) is expected to have improved to -8.6 from -11.2.
• Fed Speakers: New York Fed President John Williams.
• Today’s earnings: Goldman Sacks, Morgan Stanley, and United Airlines.
• Later this week: lots of earnings in addition to Retail Sales, Producer Price Index / PPI, housing numbers, and The Fed Beige Book. Please refer to the attached economic and earnings calendars for times and details.