After plunging 12% peak to trough at the August low, the
S&P 500 managed to bounce 8.2% higher before rolling over again post-Fed.
The selling accelerated to the downside yesterday, focusing the attention of
investors on a possible retest of the 1,867 low for the S&P, and whether or
not it will hold.
To help answer that question, let's take a closer look at
the fundamental drivers behind the stock market correction and the next
catalyst, which is just a few weeks away.
The S&P 500 has actually held up pretty well compared to
many international stock markets. U.S. stocks were locked in a narrow trading
range for over six months before the correction got underway in August.
Meanwhile, many emerging markets were already down sharply.
The reason for this divergence has everything to do with
deflation, which is the key fundamental driver behind the global stock market
decline.
First, industrial commodity prices have been plunging since
2011, with crude oil down 52% from its peak while copper prices have sunk 48%.
This is a surefire sign of global deflation, and it hits emerging market
economies particularly hard.
That's why the global slowdown showed up first in emerging
markets, but since today's world economy is more tightly integrated than ever
before, it didn't take long to spill over
into already slow-growing developed markets.
While it's true that U.S. exports to emerging markets make
up less than 5% of our GDP, emerging market economies as a whole account for
57% of world GDP growth! Weakness in emerging market leads to a slowdown in
global trade, which has a negative impact on all our trading partners,
especially Europe and Japan.
The strong dollar over the past year has intensified
deflationary pressures worldwide and magnified the slowdown in global trade.
You can see this relationship most clearly in the chart
above. Persistent weakness in the U.S. Producer Price Index (blue line) signals
intensifying deflation.
And the PPI has a very high correlation with U.S. business
sales (black line), which are also being dragged lower along with U.S.
corporate profit margins. And that's where the stock market correction comes
in.
Top line sales for S&P 500 companies are on track to
decline 2.3% in 2015 and are forecast to fall 2.9% in the third quarter,
according to Fact Set estimates, while S&P 500 earnings are expected to
decline 4.4%.
S&P 500 sales have been declining for three straight
quarters and this quarter marks the first back-to-back profit decline since
2009! So it's no wonder why investors are nervous about stock market valuations
— the P part of the P/E ratio — when sales and profit margins are declining.
Declining corporate sales and profits are feeding back into
lower U.S. GDP growth estimates. In fact, there is a growing gap between how
well economists think the U.S. is growing and what the real-time data is
saying.
The Federal Reserve Bank of Atlanta produces a forecast
called GDP Now, which is based on 13 real-time economic indicators including
housing starts, retail sales, durable goods purchases and more.
The current GDP Now forecast calls for real GDP growth of just
1.5% this quarter; that's a big disconnect compared to the "official"
Blue Chip economists' consensus estimate of 2% growth.
Earlier this year, the real-time GDP Now estimate proved to
be much closer to the mark than professional economists when the indicator
accurately forecast flat first-quarter GDP growth. If it's proven right again
this time, markets are in for a big disappointment when third-quarter preliminary
GDP data is released next month.
So what does this mean for the stock market?
* Deflation and the strong dollar have conspired to pull the
rug out from under global growth which is hurting corporate sales and profits.
* The stock market correction is all about uncertainty over
slowing economic growth and falling profit margins, which are the fundamental
foundation of stock market valuation.
Will the economy go into recession, and have profit margins
peaked? These are the questions investors are wrestling with right now and
stocks are likely to remain turbulent until we find the answers.
Over the next several weeks, we'll get the latest round of
corporate sales and profit results. And next month we'll find out about U.S.
third quarter GDP growth. Stay tuned. Good investing, Mike Burnick
Source: Money and Markets
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