Gravity in the Equities Market

01/01/2013 8:30 am EST


Keith McCullough

CEO, Hedgeye Risk Management

Former hedge-fund manager Keith McCullough talks about the effects of the earnings slowdown on the equities market.

My guest is Keith McCullough. We're talking about earnings and the slowdown there, and what effect that is going to have on the equities market here as we finish out 2012. So Keith, what are your thoughts here? What do we have to be concerned about in the equities market?

Well, really, it's gravity. I mean, economic gravity is finally starting to matter. What's really happened in the world is that economic growth has been slowing really since March. Now, a lot of people have wrestled with when this is going to stop slowing, but the reality is that we're just getting started, I think, from an earnings perspective in terms of how that translates to stocks.

A lot of people are starting to say, "Hey, look, it's a bad quarter, it's a one-up, we're going to start to rally again next year." But you know, if you look at the earnings cycle, the big corporate cycle, we're at peak all-time margins for the S&P 500. Corporate earnings in the US are at all-time peaks. Any way you slice it, 100 to 110 years of data, you're at the peak.

So that's the problem: after the peak there could be easily two to three quarters of earnings disappointment, and I think that's the bigger issue that the market is trying to deal with.

All right, so how do you play that, then? Is it a specific sector that is immune to this, or what do you do?

Well, I think...what we like to say is you don't want to be invested in pro-cyclical sectors, particularly industrial sectors or sectors that are related to the commodity bubble.

So things like Caterpillar (CAT) are a real value trap: you get a stock that people think is cheap, but it's not cheap if you're using the right numbers, and typically that's when people get sucked in. The management team has to guide down numbers by a lot, and it's going to be an ongoing affair for something like Caterpillar or anything that's really, like I said, pro-cyclical, that's anchored to the industrial cycle and Chinese demand.

So you feel like this is not built in yet, that there are still lower stock prices to come because of these bad earnings coming out, or is some of it priced in already?

Well, I mean, if you go back to 2007, it's an interesting corollary, because this is the last time corporate earnings really peaked and then rolled over for a good two to three years.

Now, when you come off these big peaks, a lot of people start to confuse market weakness with a lot of other things. People today are talking about the "cliff," but the reality is that the most important thing for stocks is earnings, and if you add the earnings wrong, that's going to give you a long, really hard look at where you can buy stock a lot cheaper.

So cheap gets cheaper, until finally that gets baked into cake, and what we try to find is stocks that have actually guided down earnings multiple times. A stock like FedEx (FDX), for example. It guided down three times like in the last three to six months.

So again, we're starting to get closer to the truth on the real earnings number. Until you know what the real number is, you can't really buy the stocks.

What about this idea that companies are holding hoards of cash, they've got tons of cash...does that help at all, even when there are lower earnings? Will they invest it and then grow their revenue and therefore earnings? What effect will it have?

The typical bull case is that the world is awash with liquidity; there's tons of cash on the balance sheet. You go back to October 2007, when the S&P 500 peaked at 1,565, that was the same case then. And then, boom, November 2007 the S&P 500 was down 4.4%.

So, again, I agree there's a lot of cash, but you'd also have to agree that there has always been a lot of cash. And on the other side of that, we can't forget that we have the biggest amount of debt, particularly on the sovereign debt side, ever. And ever is a long time. So the liability side of this is a big drain on a lot of corporate earnings anyway.

Don't forget that debt from a sovereign perspective structurally impairs growth. This is really the lesson of Japan, and I think that this is going to be an ongoing issue for companies that really have to anchor on a GDP plus or minus business that is, you know, really anchored to global growth.

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