While we have been cautious about the global economy and its impact on corporate earnings, stock markets had been ignoring those risks as investors focused on supportive low interest rates from central bankers and continued optimism about a reduction in trade tensions between the U.S. and China.   Our view has been that weaker third quarter corporate earnings reports would finally start to put some dents in that bullish view.   While the initial reports from the major U.S. banks were actually a little better than expected, the more cyclical company reports were not so optimistic.  Weak earnings and outlooks came from major players such as Caterpillar, 3M, Boeing, Texas Instruments, IBM, Fedex and even ‘perennial favourites’ Amazon and Netflix.  To our surprise, though, almost all of those stocks finished higher the day they reported, even after initial sell-offs.  How about the biggest tech giant of all, Apple Inc?  Profits fell 3%!  The stock rallied afterwards as that topped expectations, but it also marked the first time since Chief Executive Tim Cook took over in 2011 that Apple’s profit has declined in all four quarters of a fiscal year.  Revenue and profit for the fiscal year through September were both down, for the first time since 2016.

What are the insights we should take from this scenario?  The inference from these short-term trading patterns is that investors were already positioned very defensively and were waiting to buy on any weakness!  Once again, the money flows and technical condition of the market have been the bigger determinants of the shorter-term stock market moves versus the economic or corporate fundamentals on their own.  Cash positions clearly remain too high as does bearish sentiment while the low interest rate environment still leaves stocks as the better alternative, for now.   But the bigger lesson in all of this for all investors is to remember the four most important words in investing over the last few decades:  and it’s not the famous Warren Buffet phrase ‘this time is different.’     It’s “don’t  fight the Fed!”  what we’ve learned in repeated circumstances, including the rally off the year-end 2018 lows, is that once the U.S. Federal Reserve starts to aggressively loosen financial conditions, money shifts toward stocks, due both to new optimism that the lower rates will stimulate economic growth and profits, but also because the lower rates make stocks a preferred alternative.   We are once again seeing this behavior in full force as stocks have rallied off the late summer lows on the three quarter-point interest rate cuts enacted by Jerome Powell as well as the return to a ‘softer version’ of quantitative easing which will see the Federal Reserve add close to US$500 billion to its balance sheet over six months.

While we can clearly see the short-term momentum for stocks and have covered many of our Hedge Fund short positions, we continue to see plenty of warning sign for the stock market overall, not the least being our expectation that economic growth with slow further despite the recent help from the Fed.  Economies in Asia and Europe are near recessionary conditions, exacerbated by the global trade wars enacted by the U.S.  The U.S. data shows the manufacturing sector is already in recession but the talk is all about the strength of the consumer.   We wonder though, how long this strength endures as companies keep cutting back on capital spending.  At some point that has to translate into slower employment growth (or, “gasp”, employment losses!).  The bigger risk for the stock market is what this eventual slowdown with be exacerbated by the record levels of corporate debt in the U.S., most of which has been used to fund aggressive stock buybacks.  What we’ve learned from prior cycles is that it is always surprising, in retrospect, how high stocks can rise when the outlook is good to how far they can fall when those good times end.  After ten years of global economic expansion, prodded on by over US$14 trillion of negative interest-bearing debt and record global debt levels, we continue to see the risks as skewed to the downside!

Investors are breathing sighs of relief that corporate profits haven’t  waned as much as feared, giving new life to a stock-market rally that had largely stalled in the summer.

Although earnings are on track to decline for the third consecutive quarter, about 75% of the 342 companies in the S&P500 that have posted results have beaten expectations, according to FactSet, slightly above the five-year average of 72%.  While overall profits are expected to fall about 2.7% from a year earlier, the steepest decline since 2016, many analysts are now calling for a bottom, helped by an expected reduction in trade tensions.  Consensus estimates now project earnings growth to accelerate next year, helping to allay fears of a potential recession.  With 3rd quarter profit reports taking over the headlines in October, the focus has been on the number of ‘beats’ by companies on both revenue and earnings per share versus expectations.  While the market bulls tout the ‘beat ratio’ of almost 80%, this is less of a positive than it appears as companies have spent much of the last twenty years learning to ‘game the system’ by setting expectations lower each quarter and then beating those lowered numbers.   The chart below shows this more as a growing behavior than a cyclical recovery as the ‘beats ratio’ has been consistently rising, in good times and bad, for most of the past twenty years.Low expectations means more earnings 'beats'

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