Q2 EARNINGS - Negative Pre-Announcements Currently At Record Levels

FORGET THE FED: Here's The Troubling Trend That's Really Behind Stock Market Volatility 06-30-13 Factset aand Citi via BI

There's been an awful lot of belly-aching about the Federal Reserve possibly beginning to taper, or gradually reduce, its stimulative bond-buying program. Some have attributed the risk of the taper to the return of volatility in the stock markets. But this volatility may be explained more directly by a larger, more theoretically sound reason: deteriorating earnings expectations.

"[E]arnings matter the most for equities, in our opinion, and there is relatively robust statistical evidence to back up that contention," said Citi's Tobias Levkovich in a note to clients last week.

"In this respect, we have been a tad shocked by the surge in negative-to-positive preannouncement trends that make 2009’s surge appear less worrisome in retrospect. Upward earnings guidance has dipped as well and there has been little consternation or discussion about it."

FactSet's John Butters examined this trend closely recently with regard to the quarter that just ended.

"For Q2 2013, 87 companies have issued negative EPS guidance and 21 companies have issued positive EPS guidance," said Butters. "If this is the final percentage for the quarter, it will mark the highest percentage of companies issuing negative EPS guidance for a quarter."

The weirdest thing about this is that this trend has been getting worse for years and the stock market has only been going up.

"Although the number of negative preannouncements is running at an all-time high, the market is not punishing the performance of these stocks in the short term," said Butters. "For the 87 companies that have issued negative EPS guidance for Q2 2013 to date, the average price change (2 days before the guidance was issued through 2 days after the guidance was issued) was +0.1%. This percentage is well above the average of -1.2% over the past five years."

Here's a chart FactSet demonstrating this counterintuitive yet troubling trend:

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Q2 EARNINGS - Concerns Abound With Non-US Earnings

CITI: We're 'Shocked' By The Surge In Negative Earnings Preannouncements 06-24-13 Citi via BI

The S&P 500 closed at 1,573 today, which is down over 6% from its recent all-time highs.

Many have attributed much of the pullback to the hawkish tone that the Federal Reserve has recently adopted. However, stock market fundamentals have been deteriorating lately too. Specifically, earnings expectations have come down sharply. And earnings are arguably the most important driver of stocks. In his latest note to clients, Citi's Tobias Levkovich says he is "shocked" by how negative these trends have been.

The Street had become a bit too happy of late and then got upended by the Fed and the likely tapering of QE amidst some prior hopes of a delay in ending such accommodative policy, almost without spending any time looking at earnings estimates or trends less than a month before second quarter results are released. Such a thought process seems ill-founded since earnings matter the most for equities, in our opinion, and there is relatively robust statistical evidence to back up that contention. In this respect, we have been a tad shocked by the surge in negative-to-positive preannouncement trends that make 2009’s surge appear less worrisome in retrospect (see Figure 1). Upward earnings guidance has dipped as well (see Figure 2) and there has been little consternation or discussion about it.

Levkovich may be exaggerating a bit by saying "there has been little consternation or discussion about it." Indeed, plenty of people have warned about asset prices dislocating from fundamentals. They just couldn't be heard over the deafening stock market rally.

Looking forward, Levkovich doesn't think this ugly trend of negative earnings expectations to improve in the near-term.

"[W]e suspect some additional estimate cuts may be in the making when company management teams provide more realistic 2H13 outlooks in the latter part of July during earnings related conference calls," he wrote.

"While we envision an improving US economic backdrop assisting estimates, we are more concerned about international activity trends, with Europe, China and Brazil potentially generating disappointment, alongside commodity-driven economies that may have been banking on better business activity as well."

MARGIN DEBT - Rolling Over & Suggesting a Significant Correction Ahead

NYSE Margin Debt Has Ticked Down, And It Might Be Sending A Scary Stock Market Warning Sign 06-29-13 Doug Short

The New York Stock Exchange publishes end-of-month data for margin debt on the NYXdata website, where we can also find historical data back to 1959. Let's examine the numbers and study the relationship between margin debt and the market, using the S&P 500 as the surrogate for the latter.

The first chart shows the two series in real terms — adjusted for inflation to today's dollar using the Consumer Price Index as the deflator. I picked 1995 as an arbitrary start date. We were well into the Boomer Bull Market that began in 1982 and approaching the start of the Tech Bubble that shaped investor sentiment during the second half of the decade. The astonishing surge in leverage in late 1999 peaked in March 2000, the same month that the S&P 500 hit its an all-time daily high, although the highest monthly close for that year was five months later in August. A similar surge began in 2006, peaking in July, 2007, three months before the market peak.

The next chart shows the percentage growth of the two data series from the same 1995 starting date, again based on real (inflation-adjusted) data. I've added markers to show the precise monthly values and added callouts to show the month. Margin debt grew at a rate comparable to the market from 1995 to late summer of 2000 before soaring into the stratosphere. The two synchronized in their rate of contraction in early 2001. But with recovery after the Tech Crash, margin debt gradually returned to a growth rate closer to its former self in the second half of the 1990s rather than the more restrained real growth of the S&P 500. But by September of 2006, margin again went ballistic. It finally peaked in the summer of 2007, about three months before the market.

After the market low of 2009, margin debt again went on a tear until the contraction in late spring of 2010. The summer doldrums promptly ended when Chairman Bernanke hinted of more quantitative easing in his August, 2010 Jackson Hole speech. The appetite for margin instantly returned, and the Fed has periodically increased the easing.

Was April a Margin Debt Peak?

Unfortunately, the NYSE margin debt data is a few weeks old when it is published. In nominal terms, real margin debt at the end of May 2013, the latest available data, shows a slight month-over-month decline of 2.1% (1.9% in nominal terms). Will we look back at April as a cyclical peak for margin debt like we saw in 2000 and 2007? And does that anticipate a major market peak as we saw twice in the 21st century?

NYSE Investor Credit

Lance Roberts, General Partner & CEO of Streettalk Advisors, analyzes margin debt in the larger context that includes free cash accounts and credit balances in margin accounts. Essentially, he calculates the Credit Balance as the sum of Free Credit Cash Accounts and Credit Balances in Margin Accounts minus Margin Debt. The chart below illustrates the mathematics of Credit Balance with an overlay of the S&P 500. Note that the chart below is based on nominal data, not adjusted for inflation.

Click for a larger image

As I pointed out above, the NYSE margin debt data is a several weeks old when it is published. Thus, even though it may in theory be a leading indicator, a major shift in margin debt isn't be immediately evident. Nevertheless, we see that the troughs in the monthly net credit balance preceded peaks in the monthly S&P 500 closes by six months in 2000 and four months in 2007. The most recent S&P 500 correction greater than 10% was the 19.39% selloff in 2011 from April 29th to October 3rd. Investor Credit hit a negative extreme in March 2011.

There are too few peak/trough episodes in in this overlay series to take the latest credit-balance trough as a definitive warning for U.S. equities. But we'll want to keep an eye on this metric over the next few months.

TAPER SHOCK - Bank Losses

How The "Taper Tantrum" Cost US Banks $25 Billion In Q2 Net Income 06-30-13 Zero Hedge

Ever since back in 2009 the US financial system effectively suspended Mark-To-Market accounting for the too big to fail (and all other) banks (read our description of FAS 157 and 115 here), the Income Statement impact (i.e., net income above the [Other Comprehensive Income] line) of wild interest rates moves on bank balance sheets has been one thing US banks have not had to worry about. The reason for this is the transformation of large swaths of rate-sensitive holdings (the vast majority of bank assets) on the balance sheet to “Held to Maturity” meaning no matter how much higher or lower interest rates moved, banks would be immune from flowing Mark to Market losses (or gains) through the income statement.

Yet despite best effort to immunize banks from rate swings and debt MTM risk, a substantial amount of duration exposure has remained with the glorified hedge funds known as FDIC-insured bank holdings companies under the designation of “Available For Sale” (AFS) or those which due to their explicit short-term trading fate, would have to be subject to mark to market moves.

It is the bottom line impact of these securities that threatens to crush bank earnings in the just concluded second quarter by an amount that could be as large as $25 (or more) billion.

As an aside, it is technically not true that banks are devoid of GAAP rate and duration risk: over the past four years, banks had found themselves in the paradoxical situation where blowing out spreads impacting bank credit instruments (debt and CDS) due to systemic or industry-specific rate shifts, actually resulted in a boost to the adjusted bottom line since the so-called DVA impact had to be netted out from pro forma net income, leading to a non-GAAP EPS bonanza when things got really rough.

However, a far bigger issue is what happens to banks in a time when rates surge violently and dramatically in a short period of time. Such as in the past two weeks.

As we previously explained, in places like Japan, the rapid blow out in yields (with the 10Y hitting 1% coinciding with the peak of the Nikkei 225 so far in 2013) has a massive adverse impact on banks, and where a 100% parallel shift in the curve may lead to as much as a 35% impairment in bank capital.

But how about the US?

After all, while the Fed is the single largest holder of Treasurys (and whose P&L suffered a massive $200+ billion, or 4 times its “capital”, loss in June alone) courtesy of the ineffable “faith” in fiat, Bernanke has no Mark to Market restrictions (at least until such time as the reserve currency status of the USD is questioned, and so is the faith of the US central bank but that is the topic for another article) US banks do have substantial duration exposure to the tune of hundreds of billions, primarily concentrated in the spring-loaded clip known as Available For Sale securities.

So just how large is said duration exposure? According to JPM’s Nikolaos Panigirtzoglou it’s quite substantial, and amounts to a whopping $30 billion in MTM losses for every 1% increase in yields. Or in other words, the Q2 blow out in the 10 Year should have resulted in a $20-30 billion loss to the US financial system’s bottom line (through the Accumulated Other Comprehensive Income line) in the second quarter alone (all else equal, and for a hyper-levered system in which everything is contingent on smaller and smaller rates all else is never equal implying many more adverse downstream effects will likely be revealed).

From JPM:

How large is the duration risk of banks’ portfolios? The Fed's H.8 release provides some guidance on this for US banks. Each week, the Fed reports the net unrealized gain on banks’ available for sale securities. This is by no means a complete measure of banks’ duration exposure. It does not include held to maturity portfolios (albeit these are much smaller than AFS portfolios), and importantly does not include the impact of any swap hedges. Also, not all bank branches may mark their portfolios to market every day or week.

All that said, unrealized gains had fallen from $37bn at the start of May to $15bn by Wednesday of last week.

We can infer banks’ duration exposure by relating week-to-week changes in unrealized gains to week-to-week changes in the yield of our US aggregate bond index, the GABI. Figure 3 shows this beta, estimated over a rolling 6-month window to smooth through the noise in the estimate. It suggests that banks would make MTM losses on their available for sale portfolios of just under $30bn for each 1% increase in yields.

Estimating the beta over three months would give very similar results.

That beta is around twice as large as in 2010, whereas the size of banks’ bond portfolios has increased by only around 20% over that period, implying that banks in aggregate have been shifting towards longer-maturity securities. The beta of just under $30bn for a 1% rise in yields implies that the 18bp rise in GABI yields since the last H8 report would have reduced unrealized gains by a further $5.4bn.

Oops: this is precisely why when everyone is scrambling to chase yields and in the process increases duration to preserve some NIM in a centrally-planned, manipulated, collapsing rate environment (resulting in a doubling of bank duration exposure beta in under three years!) any rapid inverse move will leave everyone with massive losses. Losses that may be as much as $30 billion or more.

Putting this number in perspective, according to the FDIC, in Q1 banks recorded profits of $40 billion. There goes half of Q1 profits...

But while the US losses may be manageable, if crushing to sellside analysts who have bet the farm – once again incorrectly - on S&P 500 earnings picking up in Q2 due to a surge in financial profits which are now locked far lower at June 28th 10Y levels and resulting in billions in MTM losses that will have to hit the Net Income line, it is things in Europe that are about to get nasty once again.

US banks have been modestly reducing their bond holdings since the start of May, by around $19bn overall. By contrast, Euro area banks bought a hefty €48bn in May, largely because Italian and Spanish banks added to their holdings as spreads edged wider.

And while we don't have a convenient weekly update on banking sector unrealized losses in Europe as per the US H.8., it looks like the European periphery’s Monte Carlo double-down “all in” bluff may have just been called. Or in other words, now that the carry trade tide has gone away, we finally see how many European banks were swimming naked (for a hint from Goldman Sachs, see here). We can’t help but wonder how many of their US brethren will join them with their pants down as bank results are reported over the next several weeks.