Ameriprise Financial : Another Rally After Bad News: Is This the New Normal?

Another Rally After Bad News: Is This the New Normal?

A surprisingly soft employment report for September makes the Fed's decision to remain on hold look somewhat prescient, and despite its insistence otherwise, also lowers the odds of its intention to raise rates this year. Stocks rallied on Friday after the employment report and were rallying again on Monday, following upturns in Asia and Europe. This reaction is reminiscent of market behavior earlier in the recovery when bad news was considered good news since it raised the likelihood of additional central bank intervention. This far along, however, the reaction is somewhat surprising since economic growth is what we need most of all.

A delayed Fed move is certainly good news for emerging markets, as the threat of capital flight is reduced by the maintenance of low interest rates and relieves some of the upward pressure on the dollar. But the deceleration in U.S. job creation also suggests that economic weakness overseas is having an impact domestically. The manufacturing sector lost jobs for the second consecutive month. The length of the workweek fell slightly, and wage growth failed to accelerate.

We also learned on Friday that factory orders (ex-transportation) also fell in August for the second straight month and for the fourth month in the past five. The move higher in stocks notwithstanding, I would gladly trade slightly higher interest rates for accelerating growth.

Mixed Expectations for Third Quarter Earnings

Third quarter earnings season gets underway this week, and the results are expected to be mixed. Overall, aggregate earnings for the S&P 500 are likely to be down compared to last year, falling 5.1 percent, according to Factset. If so, it would be the second straight quarter of declining earnings growth.

Not surprisingly, the energy sector is expected to experience the biggest decline, down 65 percent. In fact, if the energy sector was excluded, aggregate earnings would be predicted to grow by 2.3 percent. Also likely to witness declines, although of smaller magnitude, are materials, industrials and consumer staples, with fractional declines in utilities and tech.

At the other end of the spectrum, telecom is forecast to show earnings growth of 18 percent, followed by consumer discretionary, healthcare and financials. Revenues are also expected to be under pressure in the quarter, with a year-over-year decline of 3.4 percent. This follows a decline in the second quarter of 3.4 percent. This point is especially noteworthy. Companies can manage expenses but they cannot conjure up sales, at least not without promotional pricing. Profit margins can be defended and enhanced through higher prices, but pricing power is in short supply in this environment of sluggish demand. It is probably fair to say that most corporate leaders would also gladly trade higher interest rates for rising revenue.

Bonds Come Under Pressure

While the recent price action in equities has been to the upside, at least for the past five days, the story in corporate bonds has been quite different. Credit spreads between high yield and government bonds have continued to widen. Over the final four days of last week, the spread between the Bank of America Merrill Lynch High Yield Master II index and the ten-year treasury has widened by 35 basis points, while the S&P 500 rallied 3.7 percent. (Halfway through afternoon trading on Monday the S&P is up another 1.6 percent).

Since September 15, the high yield spread to treasuries has widened by 130 basis points. This divergence between firming equity prices and higher low quality bond yields bears watching. To be sure, the weakness in high yield is being felt most acutely among energy issuers, but signs of deterioration elsewhere would be an unwelcome development.

Foreign markets applauded the weaker U.S. jobs report. Stocks in the Eurozone have a enjoyed a two-day rally of 4.0 percent, Brazil is higher by 5.1 percent, while Japanese equities rallied 1.6 percent and Australian stocks rallied 2.0 percent on Monday. Which begs the question - how will these markets react to good economic news?

Important Disclosures:
The S&P 500 is an index containing the stocks of 500 large-cap corporations, most of which are American. The index is the most notable of the many indices owned and maintained by Standard & Poor's, a division of McGraw-Hill.
FactSet Research Systems Inc. is a multinational financial data and software company headquartered in Norwalk, CT, United States. The company provides financial information and analytic software for investment professionals.

The Bank of America Merrill Lynch High-Yield Bond Master II Index is an unmanaged index that tracks the performance of below investment grade U.S. dollar-denominated corporate bonds publicly issued in the U.S. domestic market.

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