Oh good! Another “what could go wrong” moment.
So here’s what you have to understand. Morgan Stanley is pretty sure that what the skeptical among you think you’ve been seeing in U.S. equities this year is not in fact what you’ve been seeing.
See what the cynical among you thought was that markets were being levitated by the ongoing central bank liquidity tsunami and a completely irrational faith in the prospects for Donald Trump’s agenda which, as rates and the dollar will gladly tell you if you ask them, was D.O.A.
But really, what you were seeing was the market front-running upbeat earnings. Here’s Morgan Stanley to explain:
A similar trading pattern took place leading up to both 1Q and 2Q reporting season— the market rallied into earnings as strong beats, driven by both solid top line growth and improving margins, were priced in. Then as reporting season kicked off, stocks consolidated, leaving some wondering why price reactions to sizeable beats were so muted. Leading up to 1Q, the S&P 500 rallied by 5% from early February to early March. In the press, this was attributed to a continuation of the Pro Growth Trump trade, but in our view the move was more about the realization that 1Q earnings estimates were too low. Preceding 2Q, the market again rallied another 5% from mid May to mid July. Exhibit 1 shows how both the benchmark and the forward multiple re-rated higher into earnings and then faded as the market had already priced the strong earnings.
Ok, got it. I mean, not really because markets are obviously just doing what they’ve been conditioned to do, which is “go up”, but let’s hear Morgan out. Here’s more:
In Exhibit 2, we took a look at the 1Q and 2Q moves into earnings in a historical context. Specifically, we looked at the average performance of the S&P 500 leading up to every quarterly earnings beat of at least 5% (i.e.,a strong quarter—1Q and 2Q beats both exceeded 5%) since 2010. The results were somewhat sporadic on a quarter by quarter basis, but the price moves in 1Q and 2Q were in fact some of the strongest going into an earnings beat of that magnitude. The exhibit shows that the average price performance line for all other periods was roughly flat going into reporting season whereas the performance line for 1Q and 2Q accelerated rapidly well before earnings were released and then consolidated.
So in this regard, Q1 and Q2 2017 were anomalous. “Why did this occur?,” Morgan goes on to ask, before answering their own question as follows:
One explanation is that the low volatility environment we have experienced thus far in 2017 has coincided with a general lack of macro catalysts. Thus, with no significant catalysts present to derail the market’s response to a great quarter, the beat was priced early.
Yes, “a general lack of macro catalysts.” You know, besides Geert Wilders, Marine Le Pen, Donald Trump, North Korea, a marked divergence between hard and soft data in the U.S., a decelerating China, 26 tomahawk missiles hitting Syria, a historic diplomatic spat between Saudi Arabia and Qatar, and absolute gridlock in Washington D.C.
But other than that, there was definitely a “a general lack of macro catalysts.”
What there was definitely not a “general lack of” was central bank liquidity, which may be a better explanation for why “the low volatility environment” persisted despite a veritable laundry list of geopolitical concerns.
But let’s just assume Morgan Stanley is right (i.e. that everything we thought we saw in terms of macro catalysts was in fact just a figment of our imaginations). If stocks are again front-running what they assume will be another quarter of good earnings, what happens if earnings disappoint?
Or, coming full circle, “what could go wrong?”
Somewhere, someone is reading this and saying: “we couldn’t have said it any better ourselves.”