Sentiment and emotions aside, S&P 500 (SPY) third-quarter earnings season started in earnest last Friday, as JP Morgan (JPM) and Citigroup (C) were amongst some banks that reported numbers -- as the former beat on both the top line and the bottom line, while the latter reported a positive quarter, as well. Investment banking revenue for JPM, Goldman Sachs (GS) , Morgan Stanley (MS) and Citigroup for the first nine months of 2018 show growth of 50% to 70% on average since 2010.
So far on the scorecard, 6% of S&P 500 companies have reported for the quarter, 86% of companies reported a positive surprise and 68% reported a positive sales surprise (source: Factset). The average earnings growth rate for the quarter so far is 19.1% (third highest growth rate since the first quarter of 2011). The forward 12-month P/E ratio for the S&P 500 is now 15.7x, compared to the five-year average of 16.3x.
To put it all into perspective, there is genuine earnings growth and corporations posting profit, and the market is not expensive. But the market is currently battling with the perception of a growth slowdown vs. actual growth.
Given the selloff over the past three days, as the market has tried to breach 2750 -- the key 200-day moving average -- the question on everyone's minds is, "Is there more to go or is this just a correction?"
A close below here can symbolize something more ominous. If this level is broken, the algos will then generate "sell" signals, which can cause another leg of liquidation to the downside. There is so much negativity and every possible bearish scenario thrown at the markets right now, for it to break this uptrend that has been in place for the past five years, one really needs something a lot more marginally worse. After all, the fundamentals seem to be robust, so other than massive outperformance, there really is no justification to sell -- for the time being.
How are investors positioned? From the recent AAII institutional survey of investors, bullish sentiment had its largest one-week drop since mid-November 2017, falling 15.05 percentage points. Bullish sentiment is now down to 30.6% from 45.66% last week. This is the lowest level of bullishness since seen April this year, when it fell down to 27.09%.
The Fear & Greed Index (source CNN Business) is now firmly in the "fear" territory below 20. Generally bullish markets do not end during such levels of pessimism. There seems to be a lot more risk aversion around. Sod's law, the pain trade seems to be on the upside. After all, what can surprise investors more than a rapid move back to the highs of this year?
Now for the elephant in the room: inflation. The big debate on investors' minds currently is whether the Fed is closer to the end of its gradual rate hike cycle or closer to its neutral rate? The University of Michigan long-term consumer sentiment expectations are back below post-recession lows. Gauging by Goldman Sachs' U.S. Financial conditions index (trading close to 99.47 recently) shows how conditions have tightened recently equivalent to additional interest rate rises.
It is conceivable to start seeing softer prints in U.S. manufacturing activity as per the correlation between ISM and GS Financial Conditions Index. Could this give the Fed enough ammunition to ease off on the rate hike path? If so, the dollar is in for a good fall vs. other developed market currencies, which will boost Emerging Markets, given their dollar denominated debt.
As we get through Q3 earnings season, conference calls will be filled with the words "tariffs" and "trade wars." The key is to focus on company guidance on outlook and growth. If there is genuine earnings growth, the market will hold this level of support. Emotions can only distort markets for a short while before fundamentals take over. The risk-reward seems much better to the upside than downside for the U.S. markets, right now.