When stocks get off to a good start to the year, unpleasant surprises in the economic data often spoil the party. This typically occurs in combination with rising financial stress thanks to the usual suspects such as:
C. All of the above.
The result: Volatility spikes higher and stock prices dive lower. Indeed, this has been the pattern in each of the past three years. And the pattern unfolds right about this time of year too; beginning in March-April. As if on cue, this all too familiar pattern seems to be repeating once again in 2013 …
First, as noted in the above chart, the Bloomberg U.S. Economic Surprise Index peaked in February-March and is rolling over, as it has in each of the past three years.
Second, the European Union (EU) debt crisis was thrust back into the limelight recently thanks to the bureaucratic bungling of the Cyprus bank “rescue.”
Third, financial market volatility is predictably rising in response, with big moves recently in global currencies and bond markets. Could stocks be next?
Let’s take a closer look at the Bloomberg Economic Surprise Index (symbol: ECSURPUS:IND) shown above. The index is designed to measure the degree to which economic forecasts are living up to real-time data. In other words, whether actual results are beating or falling short of estimates.
Positive data surprises move the index higher (upper panel of chart), while negative surprises — like Friday’s unexpectedly weak March jobs report — push the index lower, as is the case now.
Historically, stock prices (lower panel of chart) have a very high correlation with this index, which makes perfect sense because the stock market itself is considered a leading indicator.
As negative economic data overwhelms positive, it is reflected pretty quickly in stock prices. That’s why peaks in the economic surprise index are often associated with peaks in the stock market; sometimes with a delay. But if U.S. economic data continues to surprise on the downside, stock prices are likely to soon follow.
This index is at 0.15 now, down from a peak of 0.45 in late February. If it decisively breaks the zero line, it could be a sign of trouble ahead.
Over the last three years, each time the index fell below the zero line and remained there for several weeks, the S&P 500 was either in the midst of a correction, or about to enter one, with an average decline of 8 percent over the next 3 months!
Also, Watch Out for Profit Surprises
As if the ongoing debt drama in Europe and softening U.S. economic data weren’t enough, there is another factor you should monitor closely in the weeks ahead: S&P 500 first-quarter profit results.
|Low earnings expectations could surprise to the upside.|
The good news: Not much is expected with S&P 500 earnings forecast to decline 0.6 percent year over year on slim sales growth of just 0.5 percent. So, perhaps the bar is set low enough to generate positive earnings surprises in the weeks ahead.
The bad news: Executives at S&P 500 companies, who should have the best insight into underlying business trends, sound quite pessimistic about their prospects.
I wrote previously about how I use management guidance as a market indicator. According to FactSet Research, of the 110 companies that have issued earnings guidance for the first quarter, 78 percent (86 out of 110) have been negative warnings, which is well above the five-year average!
Unfortunately, trends in management guidance tend to be a leading indicator for sales and profit forecasts, which in turn drive stock prices, according to Merrill Lynch research. And the one-month guidance ratio just fell to the lowest level since December 2008, when both stocks and profits were plunging in the midst of the financial crisis!
Reporting season began this week and certainly has the potential to add more volatility to markets during the month of April, depending on results and more importantly, management guidance.
Expect First-Quarter Results to
Influence Near-Term Market Direction
The current downtrend in S&P 500 profit results and downbeat management guidance are both pointing toward a potential correction in stocks. But as we’ve seen before, low estimates might prove a bit too pessimistic, which means actual results have the potential to surprise on the upside.
As always, when stocks you own (or are interested in buying) post results in the weeks ahead, don’t dwell too much on the just-reported numbers, which are backward looking anyway. Instead, focus on what management says about future business prospects.
Bottom line: In addition to Europe’s never-ending debt crisis and fading U.S. economic data, investors can add upcoming earnings results to a growing list of concerns. The odds of at least a short-term correction are on the rise.
But remember, recent stock market pullbacks have been limited to 10 percent or less, and have been a great opportunity to add to your investments, as was the case around this time last year.