6 September 2012

Global Strategy
Alternative view
www.sgresearch.com

Global Strategy Weekly

Savage acceleration in downgrades reflects acknowledgement of US recession
Albert Edwards (44) 20 7762 5890 albert.edwards@sgcib.com

The resilience of the US equity market in the face of a rapidly deteriorating profits backdrop points to continued high levels of investor hope. Hope that a US recession will be avoided; hope that US QE3 is around the corner and will work; hope that despite mounting evidence that China is hard landing, the authorities there will turn things around. By contrast, I believe that the third leg of the Ice Age de-rating in equity markets is imminent. For this secular bear market to end, investors must voluntary give up hope. Otherwise the vice-like grip of the bear will soon squeeze the hope from their gasping, broken bodies.

The quiet sideways move in the S&P during August masks a torrent of cross-currents raging under the surface. Better-than-expected July non-farm payrolls certainly seemed to calm investors going into August.

Global asset allocation

% Equities Bonds Cash
Index Index neutral SG Weight

Yet the profits deterioration in the US (and indeed elsewhere) continued at a ferocious pace a pace entirely consistent with a renewed global recession. Thomson Reuters reports that negative US company pre-announcements going into the third quarter are now running at their fastest pace since Q3 2001.

30-80 20-50 0-30

60 35 5

35 50 15

Source: SG Cross Asset Research

But the metric which really stood out for me over recent weeks was a truly awful US durable goods report. For although the headline July data rose by over 4%, both mom and yoy, the core measure of new orders has slumped (core is capital goods orders excluding the volatile aircraft component). Core orders fell 4% in July mom and 6.2% yoy. July was not a one off. This is now the fourth month out of the last five that core new orders have fallen sharply and is entirely consistent with the rapidly deteriorating profits backdrop.

If as I suspect, this is further evidence that the US economy has already entered recession, it will not be long before the US equity market reacts. Certainly, the recent pop in the market above 1425 to a post-crisis high sits badly with the facts on the ground (see chart below). Irrespective of any prospect of QE3, the market will not resist this recessionary data for long. The S&P will be led hand-in-hand by the economic cycle over a cliff into freefall. That will be the third phase of this secular valuation bear market.

Slumping durable goods orders (core) go hand-in-hand with a equity bear market
000'S 75 1600

S&P Comp (rhscale)

1500

Global Strategy Team

70 1400

Albert Edwards (44) 20 7762 5890 albert.edwards@sgcib.com Dylan Grice (44) 20 7762 5872 dylan.grice@sgcib.com

1300 65 1200

60

1100

1000 55 900

800 50 700

core durable goods orders

45 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 600

Source: Datastream

Macro

Commodities

Forex

Rates

Equity

Credit
F73452

Derivatives

Please see important disclaimer and disclosures at the end of the document

Global Strategy Weekly

My Quant colleague Andrew Lapthorne drew my attention to the torrid rate of profits downgrading at both the global and individual regional level (see Global Earnings Estimate Analysis available on request). Analysts are currently slicing around 2% a month off the level of earnings forecasts which have now fallen some 15% yoy (see chart below).
Global earnings revisions: absolute change in analysts aggregate earnings forecasts (%) and 12 months % change
1.5 1.0 0.5 0.0 -0.5 -1.0 -1.5 -2.0 -2.5

10.0

5.0

0.0

-5.0

-10.0

-15.0
-3.0 -3.5 Aug-09 Aug-10
FY1 FY2

Aug-11

Aug-12

-20.0 Aug-10

Feb-11

Aug-11
FY1

Feb-12
FY2

Aug-12

Source: FactSet, MSCI, SG Quantitative Research / Note: figures are computed from bottom-up I/B/E/S consensus earnings estimates

The good news is that analyst eps downgrades are nothing unusual. Normally analysts will ALWAYS have to downgrade their eps forecasts because they tend to be a jolly optimistic bunch of guys and gals, seeing the world through rose-tinted glasses. As the year progresses, they have to scramble back into the real world the rest of us humans live in. The bad news is that August is typically not a month which sees much in the way of downgrading. It is in the period from September to April that analysts are forced by reality to slash and burn their eps estimates (see chart below). So an almost 2% downgrade in August can be seen as very serious indeed and reflective of deteriorating underlying economic conditions. But on seasonal grounds alone we should expect to see the earnings downgrades accelerating over the next few months.
Average monthly downgrading of eps forecasts %
Jan 0.20 0.00 -0.20 -0.40 -0.60 -0.80 -1.00 -1.20 -1.40 -1.60 -1.80
Average monthly revision
Source: SG Quant

Feb

Mar

Apr

May

Jun

Jul

Aug

Sep

Oct

Nov

Dec

The weakness in corporate investment as shown by core durable goods orders may relate to a couple of key developments. Many will point to the expiry of enhanced depreciation allowances at the turn of this year as a reason investment is now weak. In addition, confidence in the economic outlook, or the lack of it, will be key determinates to the investment cycle. The prospect of the US fiscal cliff cannot be helpful in this regard.

6 September 2012

F73452

Global Strategy Weekly

But in reality we need to look no further than the profits cycle to explain weak investment. One of the key determinants of corporate investment is the growth rate of profits. To be sure, the level of profits, the free cash flow and the rate of profitability (however measured) all also help to determine investment, but history suggests that the primary driver for the change in investment seems to be the change in profits. As Thomson Reuters reports we are seeing the fastest pace of profits deterioration since Q3 2001, then we should also expect capital goods orders to be falling off a cliff which is exactly what is happening. There is worse to come. The July durable goods report shows that, despite a collapse in new orders, production and hence shipments continue at a rapid pace. The current imbalance is entirely consistent with a US economy in recession (see chart below). For it is capital goods shipments, not new orders, that go into the GDP data, as what is not shipped just piles up in inventories until capital goods producing companies bite the bullet and slash their own production schedules in line with the weak new order flow.
The ratio of core durable goods orders to shipments is also at recession levels
1.10 1.10

1.05

1.05

1.00

1.00

0.95

0.95

0.90

0.90

3 month mav
0.85 0.85

0.80 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11

0.80

Source: Datastream

We also know the weakness in orders continued in August. The US ISM manufacturing data just released showed another slippage to 47.1 from 48.0 while inventories rose from 49.0 to 53.0, the highest level for the last 12 months. Taking both ISM orders series together (new and unfilled) we can see the gradual stop/start nature of the cycle since the peak in late 2009 with orders on a clear declining recessionary trend (see chart below, dotted line). What makes this new cyclical low so worrying this year, as opposed to mid-2012 or 2011, is that the core durable goods orders/shipments ratio also shows a major problem and profits are being downgraded at a savage pace.
US ISM new and unfilled orders and core durable goods new orders/shipments ratio
1.10

ISM new & unfilled orders (rhscale)

70

65

1.05

60

55

1.00

50

45

0.95

40

35

0.90

30

core durable goods orders/shipments

25 0.85 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 20

Source: Datastream

6 September 2012

F73452

Global Strategy Weekly

The Q2 US reporting round was most notable for the torrent of misses on the top line. Revenue growth slowed sharply and stood at only 1% yoy for the S&P 500 companies in Q2. This rapid slowdown was also visible at the whole economy level, with nominal business sales slowing to 3% yoy in June (latest data!). Once again, the gradual slowdown in the yoy rates belies the slump that has occurred in sales towards the end of the second quarter. No wonder then that new orders were so weak in July and August.
US Business sales (manufacturing and trade, nominal % change)

Source: Datastream

Despite the recent weakness in the corporate sector data, most leading indicators turned upward slightly in July. The US Conference Board is fairly typical, rising 0.4% on month. The rise was led by stronger initial unemployment claims, building permits, the shape of the yield curve and stock prices which all contributed positively, offsetting the impact of weaker ISM new orders. The Conference Board themselves look at their leading indicator as a 6 month percentage change, but in the chart below we use a 3 month change, which is more timely for catching turning points. It also shows a bounce up in July even having excluded the shape of the yield curve (which we do, believing it is nonsense to include the shape of the yield curve as 10y-Fed Funds since it will never be able to contribute negatively to the leading indicator with this construction).
US Conference Board Leading Indicator (3mth change)

Source: Datastream

Returning to the topic of analysts earnings projection, we can see the close similarity between the descending wave-like pattern of the leading indicator (above) and the level of analysts earnings optimism (as measured by the % of eps estimate changes that are upgrades, dotted
4 6 September 2012

F73452

Global Strategy Weekly

line in chart below). Analyst optimism similarly registers an uptick in the latest data point, but from a lower low compared to last year in contrast with the leading indicator above. This underlines the fact that the profits situation is somewhat worse than the overall economy. But that should not leave investors sanguine on the economys prospects as we have long believed that the profits cycle leads the economic cycle a fact often ignored by many economic commentators. We show also below the change in analyst optimism - 6 percentage point month change in this instance, red line. This also has ticked up but is still just in negative territory. We find it is the change in optimism which tends to drive equity performance
The level of global analyst optimism and the change in that optimism (6 month change)
80 80

60

analyst optimism

60

40

40

20

20

-20

ch in analyst optimism

-20

-40 2003 2004 2005 2006 2007 2008 2009 2010 2011

-40

Source: Datastream

For while most commentators are attributing the S&Ps recent performance to hopes of QE3 etc, we can show that actually it is entirely in line with the earnings fundamentals of recent months (see chart below). The problem is that Andrew Lapthorne suggests that the latest uptick in the red line in now being washed away in a torrent of red ink. But that red ink is flowing even before the US government recognises that it too, like every other major western government, will have to bite the fiscal bullet in some shape or form. And for an economy either in recession (my view) or bouncing along the bottom (the optimists view) and with profits already falling, this will surely be the straw to break the camels back.
Performance in S&P closely mirrors change in analyst optimism (both 6 month change)
50 50

40

40

30

30

ch in S&P Comp
20 20 10 10

-10

-10

-20

-20

-30

ch in analyst optimism

-30

-40

-40

-50 2003 2004 2005 2006 2007 2008 2009 2010 2011

-50

Source: Datastream

And finally, while the market awaits QE3 and digests Ben Bernankes extensive justification for his unprecedented actions, I am once again reminded of that quote from Boris Johnson, the now world famous Mayor of London, who said "My friends, as I have discovered myself, there are no disasters, only opportunities. And, indeed, opportunities for fresh disasters."
6 September 2012 5

F73452

Global Strategy Weekly

APPENDIX
IMPORTANT DISCLAIMER: The information herein is not intended to be an offer to buy or sell, or a solicitation of an offer to buy or sell, any securities and has been obtained from, or is based upon, sources believed to be reliable but is not guaranteed as to accuracy or completeness. Material contained in this report satisfies the regulatory provisions concerning independent investment research as defined in MiFID. SG does, from time to time, deal, trade in, profit from, hold, act as market-makers or advisers, brokers or bankers in relation to the securities, or derivatives thereof, of persons, firms or entities mentioned in this document and may be represented on the board of such persons, firms or entities. SG does, from time to time, act as a principal trader in equities or debt securities that may be referred to in this report and may hold equity or debt securities positions. Employees of SG, or individuals connected to them, may from time to time have a position in or hold any of the investments or related investments mentioned in this document. SG is under no obligation to disclose or take account of this document when advising or dealing with or on behalf of customers. The views of SG reflected in this document may change without notice. In addition, SG may issue other reports that are inconsistent with, and reach different conclusions from, the information presented in this report and is under no obligation to ensure that such other reports are brought to the attention of any recipient of this report. To the maximum extent possible at law, SG does not accept any liability whatsoever arising from the use of the material or information contained herein. This research document is not intended for use by or targeted to retail customers. Should a retail customer obtain a copy of this report he/she should not base his/her investment decisions solely on the basis of this document and must seek independent financial advice. The financial instrument discussed in this report may not be suitable for all investors and investors must make their own informed decisions and seek their own advice regarding the appropriateness of investing in financial instruments or implementing strategies discussed herein. The value of securities and financial instruments is subject to currency exchange rate fluctuation that may have a positive or negative effect on the price of such securities or financial instruments, and investors in securities such as ADRs effectively assume this risk. SG does not provide any tax advice. Past performance is not necessarily a guide to future performance. Estimates of future performance are based on assumptions that may not be realized. Investments in general, and derivatives in particular, involve numerous risks, including, among others, market, counterparty default and liquidity risk. Trading in options involves additional risks and is not suitable for all investors. An option may become worthless by its expiration date, as it is a depreciating asset. Option ownership could result in significant loss or gain, especially for options of unhedged positions. Prior to buying or selling an option, investors must review the "Characteristics and Risks of Standardized Options" at http://www.optionsclearing.com/publications/risks/riskchap.1.jsp. Notice to French Investors: This publication is issued in France by or through Socit Gnrale ("SG") which is authorised and supervised by the Autorit de Contrle Prudentiel and regulated by the Autorite des Marches Financiers. Notice to U.K. Investors: This publication is issued in the United Kingdom by or through Socit Gnrale ("SG"), London Branch . Socit Gnrale is a French credit institution (bank) authorised and supervised by the Autorit de Contrle Prudentiel (the French Prudential Control Authority). Socit Gnrale is subject to limited regulation by the Financial Services Authority (FSA) in the U.K. Details of the extent of SG's regulation by the FSA are available from SG on request. The information and any advice contained herein is directed only at, and made available only to, professional clients and eligible counterparties (as defined in the FSA rules) and should not be relied upon by any other person or party. Notice to Polish Investors: this document has been issued in Poland by Societe Generale S.A. Oddzial w Polsce (the Branch) with its registered office in Warsaw (Poland) at 111 Marszakowska St. The Branch is supervised by the Polish Financial Supervision Authority and the French Autorit de Contrle Prudentiel. This report is addressed to financial institutions only, as defined in the Act on trading in financial instruments. The Branch certifies that this document has been elaborated with due dilligence and care. Notice to U.S. Investors: For purposes of SEC Rule 15a-6, SG Americas Securities LLC (SGAS) takes responsibility for this research report. This report is intended for institutional investors only. Any U.S. person wishing to discuss this report or effect transactions in any security discussed herein should do so with or through SGAS, a broker-dealer registered with the SEC and a member of FINRA, with its registered address at 1221 Avenue of the Americas, New York, NY 10020. (212)-278-6000. Notice to Canadian Investors: This document is for information purposes only and is intended for use by Permitted Clients, as defined under National Instrument 31-103, Accredited Investors, as defined under National Instrument 45-106, Accredited Counterparties as defined under the Derivatives Act (Qubec) and "Qualified Parties" as defined under the ASC, BCSC, SFSC and NBSC Orders Notice to Singapore Investors: This document is provided in Singapore by or through Socit Gnrale ("SG"), Singapore Branch and is provided only to accredited investors, expert investors and institutional investors, as defined in Section 4A of the Securities and Futures Act, Cap. 289. Recipients of this document are to contact Socit Gnrale, Singapore Branch in respect of any matters arising from, or in connection with, the document. If you are an accredited investor or expert investor, please be informed that in SG's dealings with you, SG is relying on the following exemptions to the Financial Advisers Act, Cap. 110 (FAA): (1) the exemption in Regulation 33 of the Financial Advisers Regulations (FAR), which exempts SG from complying with Section 25 of the FAA on disclosure of product information to clients; (2) the exemption set out in Regulation 34 of the FAR, which exempts SG from complying with Section 27 of the FAA on recommendations; and (3) the exemption set out in Regulation 35 of the FAR, which exempts SG from complying with Section 36 of the FAA on disclosure of certain interests in securities. Notice to Hong Kong Investors: This report is distributed in Hong Kong by Socit Gnrale, Hong Kong Branch which is licensed by the Securities and Futures Commission of Hong Kong under the Securities and Futures Ordinance (Chapter 571 of the Laws of Hong Kong) ("SFO"). This document does not constitute a solicitation or an offer of securities or an invitation to the public within the meaning of the SFO. This report is to be circulated only to "professional investors" as defined in the SFO. Notice to Japanese Investors: This publication is distributed in Japan by Societe Generale Securities (North Pacific) Ltd., Tokyo Branch, which is regulated by the Financial Services Agency of Japan. This document is intended only for the Specified Investors, as defined by the Financial Instruments and Exchange Law in Japan and only for those people to whom it is sent directly by Societe Generale Securities (North Pacific) Ltd., Tokyo Branch, and under no circumstances should it be forwarded to any third party. The products mentioned in this report may not be eligible for sale in Japan and they may not be suitable for all types of investors. Notice to Australian Investors: This document is issued in Australia by Socit Gnrale (ABN 71 092 516 286) ("SG"). SG is regulated by APRA and ASIC and holds an AFSL no. 236651 issued under the Corporations Act 2001 (Cth) ("Act"). The information contained in this document is only directed to recipients who are wholesale clients as defined under the Act. http://www.sgcib.com. Copyright: The Socit Gnrale Group 2012. All rights reserved. This publication may not be reproduced or redistributed in whole in part without the prior consent of SG or its affiliates.

6 September 2012

F73452