Safe On The Sidelines-------405 Days And Counting

The S&P 500 closed at 2052 on November 18,2014. That was 405 days ago, and despite the rips and dips in the interim the broad market average has gone nowhere.

So two of the Wall Street bromides that have lured punters into the casino since the March 2009 bottom are now failing. To wit, there have been about 33 attempts to rally off the dip during that period, but that gambit is self-evidently no longer working.

Likewise, fear of being left on the sidelines is rapidly abating; at some point soon safety on the sidelines will be hard to deny.
^SPX Chart

^SPX data by YCharts

By contrast, during the approximate 2,100 days between the March 2009 stock market  bottom and November 2014, there were only two periods when the S&P 500 treaded water for any appreciable period of time; and those were early in the Fed's latest cycle of bubble inflation.

Thus, between April 20, 2010 and November 9th of that year, you could have been on the sidelines for 203 days without missing any gains, and between the July 2011 debt ceiling crisis and early February 2012 there was another 190 day period of sideways action.

But other than during those two episodes, the dry spells were infrequent and increasingly shallow as the equity bubble inflated. Accordingly, during 80% of the time (1700 days) there were no extended drawdowns, plenty of dips to buy and a fairly considerable "cost" to being on the sidelines. Indeed, for the period as a whole, the S&P 500 index gained 206%.
^SPX Chart

^SPX data by YCharts

But now the market has struggled to merely drift sideways for 405 days and counting. So why are the die-hard gamblers and robo-machines still buying----even if fitfully----- when there are stiff economic headwinds gathering from all points on the global economy's compass, and when the casino itself has clearly lost its mojo? And how in the world does the mainstream financial press still blather on about 4 days left for the Santa Claus rally?

The short answer is two decades of financial repression and open-throttle money printing by the central banks have destroyed honest capital markets and completely disabled price discovery in the stock market. What is left is a mechanical routine whereby the fast money chases the chart points by the hour and day, while the Wall Street sell-side desperately attempts to lure the retail sheep with yet one more rendition of the hockey stick incantation.

But now its getting truly absurd. The 2016 consensus for ex-items earnings is currently $126 per share, meaning that there is allegedly still plenty of room for the bull to run. After all, at today's S&P 500 index level that's a forward PE of only 16.3X.

Well, not exactly. With most of the results in for Q3 2015, reported earnings for the last 12 months (LTM) came in at $90.66 per share; and those are the kind of GAAP earnings that exactly one thousand CEOs/CFOs of the S&P index companies signed as fair and accurate on penalty of jail time.

Needless to say, that LTM result doesn't bring Cramer's buy-buy-buy button to top of mind. In fact, it reflects a thumping 15% reduction from $106 per share of S&P 500 earnings reported one year ago for the September 2014 LTM period.

Stated plainly, why would you pay 22.7X for earnings that have dropped all the way back to the level ($90.95/share) reported for June 2013?

As it happens, even Wall Street's ex-items game doesn't help much, and actually points squarely at the skunk in the woodpile. Thus, if you don't count roughly $150 billion of collective S&P "nonrecurring" losses over the past year "ex-items" earnings came in at $104 per share for the September LTM period.

This magical inflation of earnings by 15%, of course, is all just Wall Street snake oil. The fact is, goodwill write-offs from failed M&A deals, restructuring charges owing to the closure of facilities and firing workers, charges for the cost of executive stock options, write-downs of inflated mineral and energy reserves and many more like and similar "one-timers" reflect the destruction of corporate cash and other real assets.

But where the true absurdity actually lies is in the hockey stick path of even these artificially bloated ex-items profits. Specifically, as of March 2014, the ex-items consensus for 2015 was a whopping $137 per share----an estimate that dropped to $118 per share by March 2015 and is now struggling to make $104.

That's right. During the last 21 months the Wall Street hockey stick has been deflated by 24%!

Still, Charlie Brown and Lucy can't hold a candle when it comes to the game of moving the football before the kick. The consensus outlook for 2016 started out at nearly the identical spot----$135 per share-----in March 2015 and has already tumbled to $126, and there is still a whole year of reality to unfold.

But here's the thing.  Why would you expect corporate earnings---even the ex-items variety----to rise nearly 20% during the coming year?

Needless to say, the headwinds are numerous and some of these will be recounted in the coming days. But two of them merit brief mention.

First, even the tepid growth of ex-items earnings in recent years was  mainly due to share buybacks and other financial engineering maneuvers. To wit, between the LTM period for September 2011 and the most recent period ex-items earnings grew from $94.64 per share to $104.

That's just 10% or 2.4% annually. And over half of that was due to shrinking the share count.

Stated differently, during the final four years of QE, corporate earnings even on an ex-items basis grew at less than 1% annually before share buybacks. And that was with the tailwinds of massive QE, rock bottom interest rates and the final phase of the global credit inflation and artificial economic boom in China and the EM.

By contrast, the Fed is now slouching toward normalization, the massive global dollar short is facing an endless margin call and world trade is heading into negative territory in the period just ahead. This time, however, these obstacles to organic earnings growth cannot be compensated by financial engineering.

The fact is, there was upwards of $8 trillion of share repurchases and M&A based share shrinkage during the last six years. On the margin, this massive equity liquidation was funded with borrowed money, not operating cash flow, and much of the latter was below investment grade.

But with the junk debt market cratering, that artificial boost to EPS is vanishing fast.

Leveraged Debt Outstanding - Click to enlarge

Secondly, there is more to the unwinding of the global credit bubble than simply bone rattling commodity deflation, a worldwide CapEx depression and shrinking trade, GDP and corporate profits. What's also happening is that the massive windfall profits generated during the 1994-2014 credit driven boom are about to be clawed back.

That is, the massive inflation of oil, metals and other commodity prices and profits were partially captured by sovereign wealth funds. The magnitude of their expansion during the past decade is staggering, as shown in the chart below. During that period these funds grew from $1.6 trillion to $7 trillion, and much of this went into dollar and euro markets for stocks and bonds.

But as the Wall Street Journal pointed out in a piece over the weekend, the days of heady accumulation of "sovereign wealth" in Saudi Arabia, Norway, Kazakhstan and dozens of commodity producers in between is over and done. What is happening now is that these funds are entering a cycle of liquidation which is unprecedented in financial history.

And it is likely to continue for years to come as the great commodity deflation runs its course.  In a word, the unnatural Big Fat Bid of the sovereign wealth funds is going All Offers as oil and commodity producers struggle to fund their budgets based on break-evens that are double or triple the $30 dollar oil price that is destined to prevail for years to come.

Now, some funds are shrinking or are being tapped by governments as oil revenues fall. That is forcing them to borrow or sell investments, potentially pressuring global markets just as other investors are pulling back from risk. Saudi Arabia’s central bank, which functions in some ways like a sovereign-wealth fund as it holds significant reserves that are invested widely, has sold billions in assets this year. Norway says it plans to tap its fund, the world’s largest, for the first time in 2016.

Call that a double whammy. The C-suite will be drastically curtailing its injection of cash into the casino because it will not be able to borrow as readily, if at all, to buyback shares and fund M&A deals; and the sovereign wealth funds will be disgorging the windfall profits that they had temporarily parked in the casino in order to compensate for the drastic plunge in current cash flow.

Even if profits do not continue to fall beyond the 15% drop already recorded for GAAP earnings during the LTM period just ended, that hardly constitutes a recipe for sustaining the massive multiple expansion that has occurred during the last several years.

Back in Q3 2013 when the S&P 500 companies posted $91 per share on an LTM basis or exactly the same number as for the most recent period, the  S&P 500 index was trading at 1600, implying a PE multiple of a hefty 17.6X.

Today it closed at 22.6X the same level of earnings. So five points of multiple contraction alone would amount to a 22% decline in the index-----and that's before recessionary forces hammer reported profits in the time worn manner.



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