Trader Talk

A pedestrian wearing a protective mask exits from the Wall Street subway station in New York, on Monday, July 20, 2020. Michael Nagle | Bloomberg | Getty Images Wall Street is getting bulled up on earnings, and that is highlighting the divide it has with Main Street. Earnings season is two days old, and already Wall Street pundits are optimistic. Corporate profits "have been more resilient than we expected and we are raising our estimates," UBS chief investment strategist David Lefkowitz wrote in a report to clients. The firm is raising its earnings estimates for the S&P 500 for both the full year 2020, and full-year 2021. Dennis DeBusschere from Evercore ISI is equally optimistic, stating that the rise in earnings would support a move in the S&P 500 toward 3,650 over the next few quarters, a 4% gain from the current level. This, after one day of (admittedly) blowout earnings from JP Morgan, Citigroup and Blackrock? It's more than that. Even before bank earnings, nearly two dozen companies — including heavyweights like FedEx, Lennar, and CarMax — that have already reported third-quarter earnings have beaten estimates by roughly 25%, an unusually wide earnings beat, according to Earnings Scout. What's going on? A combination of a slowly improving economy, a lack of earnings guidance, an overly cautious analyst community, an emphasis on corporations improving efficiency, and a belief that a vaccine will become available in early 2021 is slowly but surely nudging corporate earnings estimates higher. Analysts, who have underestimated the extent of the corporate profit recovery, are now busily revising earnings estimates upward: "There are twice as many S&P 500 stocks receiving upward earnings revisions vs. those experiencing cuts, which is well above average levels seen over the last 40 years," Ann Larson at Bernstein noted. The Main Street divide But why are earnings so much better when much of Main Street is in such dire shape? This earnings outperformance is again highlighting the difference between Wall Street — the investment economy — and Main Street — the so-called real economy. Main Street observers have long complained of this disconnect: with GDP estimated to be down 4%-5% this year and millions out of work, how could the stock market be approaching new highs? Shouldn't there be some correlation between GDP and corporate profits? There usually is, but Wall Street does not exactly represent Main Street, and the Covid downturn has highlighted those differences. The main reason for the divergence is that the U.S economy is heavily weighted to services like retail, restaurants, and doctors, rather than selling goods. But the earnings profile of the S&P 500 is more heavily weighted toward companies that sell goods. How big is the difference? UBS estimates that services comprise 83% of U.S. economic activity but only 54% of S&P 500 profits. "This is a crucial difference because spending on goods has actually increased since the pandemic hit. In contrast, spending on services has contracted fairly sharply," Levkowitz wrote. That goes a long way toward explaining the Wall Street/Main Street disconnect. The strong showing from goods companies is one reason the earnings decline this time has not been nearly as bad as 2009, when both goods and services collapsed. Third-quarter earnings are expected to have declined by roughly 20% in the third quarter, but the second quarter, when earnings declined 30%, is likely the trough for earnings, UBS noted. By contrast, earnings dropped 45% in 2009 from peak to trough. That's not all: publicly traded companies have been able to take more advantage of the Fed's programs to support the economy and have been able to raise more debt through the public markets. They also have had more exposure to the work-from-home trends that have accelerated during the pandemic, as witnessed by the huge run-up this year in shares of Apple, Microsoft, Amazon, Alphabet and Facebook. Earnings have been so strong it's reasonable to ask, is this the best it's going to get? The issue, as UBS' Levkowitz admits, is that earnings remain hostage to Covid-19 and the elections: "The range of outcomes for S&P 500 profits remains wide due to uncertainties about: the timing of vaccine availability; the size and timing of additional fiscal stimulus; and possible changes to corporate taxes in a Democratic sweep election outcome," the firm wrote. What about stock prices? If you're expecting a huge run-up in prices, it's already happened, with the S&P only 2% from an historic high. "Unfortunately, price action following beats was extremely muted last quarter," Jonathan Golub at Credit Suisse noted.
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A view of NASDAQ in Times Square during the coronavirus pandemic on May 7, 2020 in New York City. Noam Galai | Getty Images Entertainment | Getty Images In the ETF space, success begets success. Just look at what Invesco is doing Tuesday. It's launching a new product, the Nasdaq Next Gen 100 ETF (QQQJ). It might more appropriately be called the Nasdaq 100 Junior Varsity list. The Invesco QQQ Trust (QQQ) started tracking the Nasdaq 100 Index in 1999. Since then, it's become the fifth-largest ETF listed in the U.S., with $135 billion in assets under management. Now, Invesco is looking to capitalize on the interest in technology and growth stocks by offering a new "junior" QQQ. Any why not? QQQ is up nearly 40% this year. Shares outstanding are up nearly 20% since March, a sign of the exploding interest in the growth stocks the fund is famous for. The Invesco Nasdaq Next Gen 100 ETF will consist of 100 mid-cap companies that are using technology in interesting or innovative ways. Included are obvious tech choices like Seagate and internet security firm Zscaler, but also companies like Garmin, Lyft, and social game developer Zynga, not necessarily tech companies. Why, in an ETF known for tech heavyweights, would it want to include nontech companies? "QQQJ will give investors access to 100 mid-cap companies using technology to disrupt their sector," said John Hoffman, Invesco's head of Americas ETFs. "While this does include companies in the technology sector, the commonality across these companies is their legacy of using innovation and technology to create competitive advantages across multiple sectors and industries." Besides, the Nasdaq 100 has never been exclusively about tech. It has always had a healthy weighting of consumer stocks (Pepsi), consumer cyclicals (Costco, Starbucks), and even health care (Amgen). This junior QQQ is part of a series of new products Invesco is launching around the QQQ on Tuesday, which Invesco is calling an "Innovation Suite." Also launching is the Invesco Nasdaq 100 ETF (QQQM), a lower-cost version of the QQQ for longer-term buy and hold investors, Invesco Nasdaq 100 Index Fund (IVNQX), a mutual fund tied to the QQQ for investors (like some retirement plan advisors) who can't invest in ETFs but can invest in mutual funds, and the Invesco Nasdaq 100 Growth Leaders Portfolio (QQQG), a unit investment trust. This isn't the first time we have seen a "junior varsity" version of an ETF. In 2009, Van Eck, on the heels of its very successful Gold Miners ETF (GDX), launched its Junior Gold Miners ETF (GDXJ), which has become a regular part of the gold trading space.
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People walk by the New York Stock Exchange (NYSE) in lower Manhattan on October 5, 2020 in New York City. Angela Weiss | AFP | Getty Images Stock market bulls, rejoice.  Third quarter earnings season begins Tuesday with JPMorgan Chase.  The good news: in the second quarter, companies delivered surprisingly large earnings beats as analysts underestimated the strength of the recovery.  That is happening again. The bad news: fourth quarter earnings — which is the quarter now on the minds of traders — remains hostage to the vaccine and reopening story, and to a lesser extent to the election.  Third quarter estimates rising, an unusual development  In most quarters, estimates for the quarter start out high, and then are adjusted downward — typically by 3% to 5% — as the quarter ends because analysts are too optimistic. Not in the third quarter.  Analysts started out assuming that the S&P 500 would see an earnings decline of 25% compared to the same period last year.  But that was the bottom, and the estimates have been steadily improving since:  S&P 500 Q3 earnings:  improving July 1:              down 25.0% September 1:  down 22.4% Today:             down 21.0%  (Source:  Refinitiv) Still, it's a pretty bad number.  If the decline comes in at down 21%, "[I]t will mark the second largest year-over-year decline in earnings reported by the index since Q2 2009," according to John Butters, who tracks earnings for Factset. Early reporters are killing it  Another encouraging sign:  of the 22 S&P 500 companies that already reported, 20 beat estimates, a much higher beat rate than usual. And they are beating by a very wide margin of 25%, according to Nick Raich, who tracks corporate earnings at Earnings Scout.  That is way above historical averages.  Typically, companies will beat by 3% to 5%.  This implies, Raich said, than analysts are again underestimating the extent of the recovery.  "Analysts have not had the benefit of corporate guidance, and without that guidance they assumed the worst, and the worst has not come," Raich told me. Most importantly, the majority of the companies that have reported are seeing their fourth quarter earnings estimates raised by analysts, a sign that it is not a one-quarter fluke.   Early reporters like Darden, FedEx, CarMax, Lennar, AutoZone, and Nike saw their fourth quarter estimates raised due to either commentary or their strong third quarter performance. Guidance is still light, but commentary is more positive In the second quarter, the markets cratered when corporate America decided that the economy was so bad they would, for the most part, stop providing guidance.  Wall Street freaked out. There is still a problem providing longer-term guidance for many companies.  More than 25% of the companies in the S&P 500 are still not providing any earnings guidance for 2020 or 2021, according to Factset.  However, some companies are starting to loosen up on near-term quarterly guidance.   "[I]t does appear that some S&P 500 companies have better visibility on future earnings heading into the third quarter earnings season than they did heading into the second quarter earnings season," Factset's Butters said in a recent note to clients.  You can see that for the third quarter.  While the number issuing guidance was still below normal, more companies issue positive guidance than negative guidance.  That is the opposite of what usually happens.  Of 69 companies that gave guidance, 46 were positive, 23 were negative.   So what does this mean for markets in the fourth quarter?  Unfortunately, for veteran trader Art Cashin from UBS, while the good earnings news remains a tailwind, the market remains hostage to Covid headlines.  "Earnings will be important but not a dominant factor, because any news on the virus and any sudden change on reopening or the economy is what is really going to move the markets," he told me.   "This is not a normal earnings season."
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The New York Stock Exchange is pictured in the Manhattan borough of New York City, New York, October 2, 2020. Carlo Allegri | Reuters Some are calling it "a la carte stimulus," with aid for airlines in Column A, PPP aid in Column B.  Whatever it is, hopes for stimulus — preelection, postelection, comprehensive package, stand-alone deal, whatever and whenever — is supporting breakouts in cyclicals like industrials, materials, consumer discretionary and banks. Many big names like Caterpillar, Eaton and FedEx have broken to new highs. Materials stocks like Martin Marietta, Vulcan Materials and Nucor are up 10% in the last week. Even bank stocks like US Bancorp are breaking out to multimonth highs.  For some, the cyclical rally is getting way too stretched. "The action over the last couple weeks is baking a lot of positive news into the market," said Jack Miller, head of trading at Baird. Alec Young, chief investment officer at Tactical Alpha, agrees. "We are quietly getting overbought. The market is looking a little tired, the size of the rallies is getting smaller, with little waves of selling," he said. "It's true cyclicals are rallying, but they have not shown any ability to do longer-term rallies." "I don't think this market is very compelling, and I am pulling back and waiting to see what happens," he added. Others also have doubts about this rally. They note that volume on up days has been notably light while on down days it's notably heavier. This implies there's not much buyer conviction, that much of the rally is simply sellers holding onto stocks unless prices rise. Jim Besaw, who manages $3 billion as chief investment officer at GenTrust, said this signals that many still don't believe the rally: "The market is underpositioned. That's why the markets go up on light volume days.  The pain trade is still higher because most people are underweight the market." So is the market moving on a pipe dream? Besaw doesn't think so.  "Stimulus will get done," he said. "If we have another big downturn like we did in March, it will get done sooner rather than later, but it will get done." As for the outperformance of cyclicals,he said: "Biden ahead brings in the likelihood that infrastructure will likely be very high on the list, and that is why materials and industrials are outperforming." Still, what if there is no stimulus until well after the election? Could the market handle that? Besaw thinks it could: "If Biden continues to poll well, there is still room for the markets to run, particularly if corona cases don't increase dramatically. When investors are underweight, you don't necessarily need good things to happen to have the market go higher, you just need the absence of bad things."  For the moment, traders are not as focused on the other side of the story — that Biden would likely mean higher taxes and weigh on stocks. "You can say that means higher taxes, but the market seems to be saying that the contested election was an even bigger issue," Besaw said. So what should traders do? Besaw agrees it's tricky to add equity risk, and that option prices are high now.   His advice to bullish clients is to use call spreads. For example, buy a higher strike call on the S&P 500 (say 3,700) and then sell an even higher strike call (say, 3,800). "So if everyone goes smoothly and there is no contested election, and if the market goes through 3,800 (up 10% from where you are now), the call spread you bought" would net a handsome profit.
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