Volatile markets ignite "animal spirits" among all participants, provoking individuals to act on emotion rather than rationality. Scroll back to Monday, April 20 (a week ago) and remember the steady relentless sell off, pulling the Dow Jones Industrial Average down roughly 300 points. The weekend trading break has been too much for markets to digest in recent weeks, where this past Saturday and Sunday saw headlines related to the global outbreak of the virus known as "Swine Flu".
While treading carefully to avoid any politically correct toes, there are interesting parallels to be drawn between the fear of Swine Flu and that of a crumbling financial system. Last weekend language from the president, regulators, and industry CEO's threatened the banking system. Headlines were speculative of future problems such as credit card defaults, government conversion of preferred to common equity, and rates of mortgage default. Similarly, the Swine Flu scare diluted market optimism as the trading week began.
Speculators placed bets against disease fearful consumers during pre-market trading but confidence re-emerged as markets opened and earnings from Humana (HUM), Whirlpool (WHR) and Corning (GLW) beat estimates. Predictions from most corporations and analysts leading into 2009 Q1 were unrealistically low, causing many firms to beat estimates this earnings season. Each time a major corporation reports another "earnings beat" the confidence of bulls increases parallel to the complacency of bears.
The battle between "top down" and "bottom up" analysis wages on as both sides tread for a solid foundation to their arguments. Top down analysts cite macro economic data as evidence while making cases for an improving or declining economy, yet most currently endorse a "glass half empty" sentiment leading forward. The bottom up school of thought emphasizes firms, industries and countries, making inferences about the global economy as a sum of smaller parts. This approach can be very useful to traders and investors, but only if the strength of firms is analyzed honestly and objectively.
Imagine a scenario where the market had been less pessimistic leading into U.S. Q1 results, but that firms actually performed the same over the three month period. Assuming that profit estimates for firms were higher than actual results, the market would be selling off and citing the majority of negative economic data as proof. Instead the outlook prior to earnings overshot the negative results from U.S. firms and has caused an abundant frothy chatter as each firm reports "better than expected" results.
Those who are short the market understand this and aren't foolish enough to push further capital in front of firms as they beat earnings while sheepish investors build strategies around the hype. As earnings finish clocking in, the ball must bounce back into the court of the "top down" boys who have dominated downward trends from short positions.
Will the HPI come in much better than expected or store sales find a joyful pop? Perhaps consumer confidence will remain low for April and mortgage refinancing will run out of steam. Optimistic investors will hope for a down trend in initial jobless claims and a pop in personal income/outlays. But will Friday's manufacturing index and factory orders be the dark chocolate icing on a sluggish economic cake?
The proof may be in the pudding but the pudding isn't earnings season... The equity market will show its true colors as it faces hard economic data without "better than expected earnings" contributing to the euphoric aura surrounding current market projections.
