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Slumping durable goods orders (core) go hand-in-hand with a equity bear market

Slumping durable goods orders (core) go hand-in-hand with a equity bear market

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Published by: annawitkowski88 on Sep 06, 2012
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05/29/2013

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Macro Commodities Forex Rates Equity Credit Derivatives
Please see important disclaimer and disclosures at the end of the document
6 September 2012
Global Strategy
 Alternative view
www.sgresearch.com
Global Strategy
Weekly
Savage acceleration in downgrades reflects acknowledgement of US recession
Albert Edwards
(44) 20 7762 5890albert.edwards@sgcib.com
Global asset allocation
%
IndexIndexneutralSGWeight
Equities 30-80 60 35Bonds 20-50 35 50Cash 0-30 5 15
Source: SG Cross Asset Research
Global Strategy Team
Albert Edwards
(44) 20 7762 5890albert.edwards@sgcib.com
 
Dylan Grice
(44) 20 7762 5872dylan.grice@sgcib.com
The resilience of the US equity market in the face of a rapidly deteriorating profits backdroppoints to continued high levels of investor hope. Hope that a US recession will be avoided;hope that US QE3 is around the corner and will work; hope that despite mounting evidencethat China is hard landing, the authorities there will turn things around. By contrast, I believethat the third leg of the Ice Age de-rating in equity markets is imminent. For this secular bearmarket to end, investors must voluntary give up hope. Otherwise the vice-like grip of the bearwill soon squeeze the hope from their gasping, broken bodies.
 
The quiet sideways move in the S&P during August masks a torrent of cross-currentsraging under the surface. Better-than-expected July non-farm payrolls certainly seemed tocalm investors going into August.
 
Yet the profits deterioration in the US (and indeed elsewhere) continued at a ferociouspace
a pace entirely consistent with a renewed global recession. Thomson Reutersreports that negative US company pre-announcements going into the third quarter are nowrunning at their fastest pace since Q3 2001.
 
But the metric which really stood out for me over recent weeks was a truly awful USdurable goods report. For although the headline July data rose by over 4%, both mom andyoy, the core measure of new orders has slumped (core is capital goods orders excludingthe volatile aircraft component). Core orders fell 4% in July mom and 6.2% yoy. July wasnot a one off. This is now the fourth month out of the last five that core new orders havefallen sharply and is entirely consistent with the rapidly deteriorating profits backdrop.
 
If as I suspect, this is further evidence that the US economy has already enteredrecession, it will not be long before the US equity market reacts. Certainly, the recent pop inthe market above 1425 to a post-crisis high sits badly with the facts on the ground (seechart below). Irrespective of any prospect of QE3, the market will not resist this recessionarydata for long. The S&P will be led hand-in-hand by the economic cycle over a cliff into free-fall. That will be the third phase of this secular valuation bear market.
Slumping durable goods orders (core) go hand-in-hand with a equity bear market
Source: Datastream
9798990001020304050607080910111213000'S455055606570756007008009001000110012001300140015001600
 
9798990001020304050607080910111213000'S455055606570756007008009001000110012001300140015001600
core durable goods ordersS&P Comp(rhscale)
F73452
 
Global Strategy Weekly 
6 September 20122
My Quant colleague Andrew Lapthorne drew my attention to the torrid rate of profitsdowngrading at both the global and individual regional level (see Global Earnings Estimate Analysis
available on request). Analysts
are currently slicing around 2% a month off the
 level 
 of earnings forecasts which have now fallen some 15% yoy (see chart below).
Global earnings revisions: absolute change in analysts aggregate earnings forecasts (%) and 12 months % change
Source: FactSet, MSCI, SG Quantitative Research / Note: figures are computed from bottom-up I/B/E/S consensus earnings estimates
The
 good news
is that analyst eps downgrades are nothing unusual. Normally analysts will ALWAYS have to downgrade their eps forecasts because they tend to be a jolly optimisticbunch of guys and gals, seeing the world through rose-tinted glasses. As the year progresses,they have to scramble back into the real world the rest of us humans live in.The
 bad news
is that August is typically not a month which sees much in the way ofdowngrading. It is in the period from September to April that analysts are forced by reality toslash and burn their eps estimates (see chart below). So an almost 2% downgrade in Augustcan be seen as very serious indeed and reflective of deteriorating underlying economicconditions. But on seasonal grounds alone we should expect to see the earnings downgradesaccelerating over the next few months.
Average monthly downgrading of eps forecasts %
Source: SG Quant
The weakness in corporate investment as shown by core durable goods orders may relate to acouple of key developments. Many will point to the expiry of enhanced depreciationallowances at the turn of this year as a reason investment is now weak. In addition,confidence in the economic outlook, or the lack of it, will be key determinates to theinvestment cycle. The prospect of the US fiscal cliff cannot be helpful in this regard.
-3.5-3.0-2.5-2.0-1.5-1.0-0.50.00.51.01.5Aug-09 Aug-10 Aug-11 Aug-12
FY1 FY2
-20.0-15.0-10.0-5.00.05.010.0Aug-10 Feb-11 Aug-11 Feb-12 Aug-12
FY1 FY2
-1.80-1.60-1.40-1.20-1.00-0.80-0.60-0.40-0.200.000.20JanFebMarAprMayJunJulAugSepOctNovDec
Average monthly revision
F73452
 
Global Strategy Weekly 
6 September 20123
 
But in reality we need to look no further than the profits cycle to explain weak investment. Oneof the key determinants of corporate investment is the
 growth
rate of profits. To be sure, thelevel of profits, the free cash flow and the rate of profitability (however measured) all also helpto determine investment, but history suggests that the primary driver for the
change
ininvestment seems to be the
change
in profits. As Thomson Reuters reports we are seeing the fastest pace of profits deterioration since Q32001, then we should also expect capital goods orders to be falling off a cliff
which isexactly what is happening. There is worse to come. The July durable goods report shows that,despite a collapse in new orders, production and hence shipments continue at a rapid pace.The current imbalance is entirely consistent with a US economy in recession (see chart below).For it is capital goods shipments, not new orders, that go into the GDP data, as what is notshipped just piles up in inventories until capital goods producing companies bite the bulletand slash their own production schedules in line with the weak new order flow.
The ratio of core durable goods orders to shipments is also at recession levels
Source: Datastream
We also know the weakness in orders continued in August. The US ISM manufacturing data just released showed another slippage to 47.1 from 48.0 while inventories rose from 49.0 to53.0, the highest level for the last 12 months. Taking both ISM orders series together (new andunfilled) we can see the gradual stop/start nature of the cycle since the peak in late 2009
 with orders on a clear declining recessionary trend (see chart below, dotted line). What makesthis new cyclical low so worrying this year, as opposed to mid-2012 or 2011, is that the coredurable goods orders/shipments ratio also shows a major problem and profits are beingdowngraded at a savage pace.
US ISM new and unfilled orders and core durable goods new orders/shipments ratio
Source: Datastream
93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 110.800.850.900.951.001.051.100.800.850.900.951.001.051.10
3 month mav
98 99 00 01 02 03 04 05 06 07 08 09 10 11 120.850.900.951.001.051.102025303540455055606570
ISM new & unfilled orders(rhscale)core durable goods orders/shipments
F73452

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