Prices Paid And Coming Earnings Weakness
The Philadelphia Federal Reserve released their regional manufacturing survey this morning which showed an uptick to 7.3 in January from December's downwardly revised reading of 6.8 (previously 10.3 before revisions). The internals were mostly positive as well as upticks in future expectations. That is the good news. However, the not so good news is that this level is only slightly above contractionary levels and well below the March 2011 peak of 39.2.
One of the big concerns for us has been corporate earnings. The 4th quarter earnings season is underway and so far it has been less than impressive considering the numerous downward revisions that have occurred up to this point. One of the things that we watch carefully in the manufacturing reports is the "Net Prices Paid" which is simply the difference between the prices paid versus the prices received components of the surveys. There have only been a few times going back to 1968 where the Net Prices Paid index has surpassed 40 as indicated on the chart. At these levels corporate earnings have typically been negatively impacted as corporate profit margins erode.
Currently Wall Street analysts continue to extract current earnings trends ever higher into the future (current estimates for reported earnings are $99.31 for 2012 and $106.16 for 2013). This leaves stock prices very vulnerable to the inevitable reversion of earnings through the normal economic and business cycles. With earnings currently pushing to new all-time highs, and projected to go substantially higher, the risk to the reversion in earnings has increased.
With the economy already growing at a much weaker rate than was originally hoped for in 2011, and 2012 growth estimates being downwardly revised, there is quite a bit of room for weakness to show up in corporate earnings. While the economy has up-ticked as of late due to the rebound from the Japan/Debt Ceiling/Euro-Crisis trifecta that "pent up demand" has likely run its course. It is important to always separate the "forest from the trees" when looking at the data.
Our Streettalk Economic Composite Indicator (a weighted average of the major Fed manufacturing surveys, composite ISM index, NFIB, LEI, Chicago Fed National Activity Index and others) when smoothed to a 6-month average is at levels that are normally associated with a recessionary environment. Whether or not we are in, or about to be in, a recession is a debate for the mainstream media. For investors the importance of this information is to real turning points, versus intermediate bumps, in the business and economic cycle which will ultimately impact earnings and returns.
The economy is currently in a very treacherous position and is highly susceptible to external shocks from the Eurozone or even another Debt-ceiling debate show down. We need to continue to see improvement in the underlying components going forward to become more comfortable that the current rebound is more than just a bounce. With the markets very overbought on a short term basis it is recommended that investors only add equity risk exposure to the markets on corrections and maintain risk controls. (Review - Markets Issue A Buy Signal)