The Week Ahead: Earnings Take Center Stage

Last week’s data was more or less in-line with my expectations; excluding the stronger than anticipated manufacturing numbers. However, for the reasons I outlined in my previous posting, considerable downside risks remain in place for the ISM over the coming months. Friday’s lower than expected payroll data combined with deteriorating jobless claims has likely convinced the vast majority of investors that the US is in the midst of a recession. This is probably good news for equity markets, especially in terms of reducing volatility. The fact that it is widely agreed the US is in a recession should remove a level of uncertainty from the market. Investors will begin analyzing data to determine the length and severity of the recession, and not whether or not a recession will occur. I believe this should help reduce market volatility around data releases which demonstrate slight deviations of actual vs. consensus forecasts. To put it simply, you expect to see negative data during a recession… (Just not too negative)

Additionally, it appears the market has mostly accepted the fact that the Fed is near the end of this rate cut cycle. This means the market should not be as concerned about indicators, such as CPI, effecting potential future rate cuts. However, if Core CPI and/or Core PCE were to rise drastically (+3.0% yoy) a situation could arise where the Fed contemplates increasing rates, but this scenario is unlikely in the short term.

The upcoming week will be relatively quiet in terms of economic data (Consumer Credit on Monday, Claims and Trade Balance on Thursday, and Import Prices and Consumer Sentiment on Friday). However, this week brings the start of earnings season, which has the potential to bring some volatility to the market. Here is this week’s earnings calendar according to Yahoo Financial:

Earnings Calendar from Yahoo Finance


Source: Yahoo Finance

Now What? The Week Ahead

Last week’s performance was pretty much in-line with our expectations, as outlined in our March 2^nd post. But what’s going to happen this week? The beginning of this week is going to be relatively quiet on the data front. However, we will be ending the week with some important consumer related data including CPI, Retail Sales, and Consumer Sentiment (See calendar below).

Nevertheless, the main question this week will be whether or not the Fed cuts rates before the March 18^th meeting and if so by how much. First the easier question, we anticipate the cut will be 75bp. Now the harder one, we think that we are close enough to the March 18^th meeting for the Fed to wait. However, this will be very market dependent. If the market experiences a significant sell-off, then we are likely to see the Fed to act early. Typically, when the Fed delivers unexpected news (such as a rate cut) it usually occurs between 8:15AM and 8:30AM, so please be on the lookout if this scenario does plays out.

If you believe, like us, the Fed would intervene to stem any significant sell-off, then this week could turn into a good buying opportunity. Essentially, the potential Fed rate cut would work as a partial hedge against market risk, not a bad deal. The Fed has a tendency of not disappointing market expectations, and this will not change in the short-term, especially now. So if the market does experience a significant sell-off we would expect the Fed to act (as they did on Jan. 22^nd) and potentially generate at least a short-term rally (See chart below for SP500 performance during the Jan. 22^nd cut). At the same time, if the market does not experience a sell-off, the increased likelihood of a 75bp cut at the next Fed meeting should help bolster market performance.

S&P500 performance during Jan. 22nd inter-meeting rate cut

Market performance will remain very dependent on news from the financial industry and economic data releases. Here are the economic releases that could affect the market this week:

Monday March 10th:
None

Tuesday March 11th:
8:30AM: International Trade (Risk: Neutral)- According to Bloomberg.com the market is currently expecting a trade deficit of USD59.5bn vs. USD58.8bn last month.

Wednesday March 12th:
None

Thursday March 13th: Key Day in a Quiet Week
8:30AM: Retail Sales (Risk: Slight Upside)- According to the consensus survey Retail sales are expected to increase 0.2% M/M for both the headline and core reading. There could be some upside to this release from better than expected sales figures for discount retailers such as Wal-Mart

8:30AM: Import Prices (Risk: Slight Downside)- Bloomberg.com currently states a market consensus of +0.6% M/M change in import prices. Increased commodity and food prices will continue to put pressure on import prices. The big concern is how strong the pass-through effect will be to the overall CPI.

8:30AM: Jobless Claims (Risk: Downside)- Bloomberg.com currently states the market is expecting a reading of 358K. We find this to be one of the most important indicators for the health of labor market. Given continues weakness in the labor market, and signs that the commercial construction industry may be on the verge of slowing; we believe this number has the potential to surprise to the upside. Basically, any reading below 350K is considered relatively healthy, and above could warn of a recession. The 4wk moving average currently stands at 359,500. Non-farm payrolls tend to be a lagging indicator of overall economic health, while jobless claims tend to be a leading indicator, hence its importance.

10:00AM: January’s Business Inventories (Risk: Neutral)- The consensus survey expects business inventories to increase 0.5% M/M.

Friday March 14th:
8:30AM: Consumer Price Index (Risk: Neutral/Slight Downside)- The consensus survey is expecting a 0.3% and 0.2% M/M increase in CPI and Core CPI, respectively. Growing food prices, high commodity prices, and a weak dollar will continue putting upward pressure on CPI. However, how much of this will be nullified by decreased demand is yet to be seen. For more on the importance of inflation and Fed Cuts please see our Feb. 27^th posting (http://fiateconomics.blogspot.com/2008/02/fed-cuts-inflation.html).

10:00AM: Consumer Sentiment (Risk: Downside)- The market is currently expecting a reading of 69.5 after experiencing a free fall last month to 69.6. Given last month’s drop it is hard to make an accurate measurement, but we believe it is likely to come in below current expectations.

*Investment Idea:

We believe the fact that the Fed has always delivered news of inter-meeting rate changes to the market at around 8:15AM EST can be used to our advantage. Take this for example, if the market experiences a significant sell-off and an inter-meeting cut seems likely, you could purchase futures on U.S. Indices just prior to the 8:15AM EST expected announcement. If the cut does occur, then we should see a rally in future prices, and the position could be unwound within 15 minutes. If a rate cut does not occur, the position could be sold within a very short time frame helping to minimize any losses. Since you are only holding the position for a short period of time downside risk should be relatively mild, while potential upside if the cut does occur could be significant. However, you could face other risks such as negative company or sector news being released while you are holding the position. This notwithstanding, if this scenario comes about we believe the risk is worth the potential short-term gain.

*There is substantial risk in trading futures, so please make sure you know what you are doing! Also, this is an investment idea not advice so trade at your risk.

A Potential for Blood-letting: The Week Ahead

This week has some serious downside potential... Lets take a look at some of the more important indicators, and see which direction we think the risk lies verse expectations.

Monday:
10:00AM: ISM Mfg. Index (Risk: Downside)- Currently, the market expects a reading of 48.1, verse 50.1 from the prior month. We believe given the poor performance of the regional surveys (Philly & NY Fed) and consumer confidence we could see some downside risk to the markets expectations. At the same time, it will be very important to look at the new orders and prices paid sub-component of the report. New orders tends to be a rather good forward looking indicator for the index, and of course prices paid will tie in heavily to current inflation concerns. Bottom line, we could see a strong headline number and still see the market catch a bid, or vice versa based on these sub-components.

10:00AM: Construction Spending (Risk: Downside)- The market is anticipating a 0.7%m/m decline in construction spending. The reason we see a downside risk to this indicator is because housing related indicators have continue to decline, and the most recent Senior Loan Officer Survey indicated a further tightening to lending standards. This data will, despite its importance, likely take a back seat to the ISM report being released at the same time. This release will most strongly be felt in the homebuilder stocks (ex. ETF: ITB). This indicator also tends to be a good indicator of the effectiveness of Fed Policy.

Tuesday:
None

Wednesday:
8:15AM: ADP Employment Report (Risk: Neutral)- Not much I can say about this, other than it will set the mood for Friday's Non-farm release, and get a lot of media attention. If this release were to come in higher than expectations we could see a slight rally in the market. However, the inverse is true as well. Currently, the market wants to see news that would support a rate cut, but at the same time not signal an imminent recession.

8:30AM: Productivity and Costs (Risk: Neutral)- We do not expect many changes from the previous number. However, pay attention to any outliers as it will affect the market.

10:00AM: Factory Orders (Risk: Neutral)- The market is currently expecting a reading of -2.5%, based on the recent weakness in durable good orders. We feel this expectation prices the weakness in durable goods in fairly well. This would be the first decline in factory orders in 5 months.

10:00AM: Non-Manufacturing ISM (Risk: Neutral/Slight Upside)- The markets expects Non-Manufacturing ISM to come in at 47.5, after falling to 44.6 last month from well above 50. Though not as important as the manufacturing ISM, this indicator is starting to garner more attention. However, we do not believe this indicator will be enough to turn-around market sentiment if the week plays out as we are expecting.


Thursday:
8:30AM: Jobless Claims (Risk: Neutral)- We believe the initial claims number will remain above 350K, with the 4wk moving average continuing to edge up. This is bad news for the market. Initial jobless claims tend to be one of the best forward looking indicators at predicting a recession. A number below 350K tends to be safe, and above that level the probability of a recession increases dramatically.

Friday: The Main Event!
8:30AM: Employment Report (Risk: Negative)- Currently, the market anticipates an unemployment reading of 5.0% (vs. 4.9%) and an increase in non-farm payrolls of 25K. However, given the recent weak performance in initial claims we believe February's number has the potential to disappoint. We will further clarify our view once we see this week's jobless claims data and the ADP report.



Conclusion:
The bottom line is we expect another volatile week of trading without much upside. However, we could see another good buying opportunity come the end of the week. We believe once the market comes to a consensus on whether there will be or not be a recession in the US a lot of the volatility caused by uncertainty will be taken out of the markets and we may start to see the beginning of a sustainable recovery, of course the recovery would be quicker given the latter scenario.