Inertia > China.  Inertia > Earnings?

I’ve long asserted that US-based investors’ best skill was ignoring the rest of the world when it suits them.  Today’s trading is no exception.

While many US investors were either finishing up a summer weekend or asleep, China released economic reports that were below consensus.  On a year-over-year basis, GDP rose by 6.3%, which sounds quite robust, but was below the 7.1% forecast.  Remember, at this time last year, much of China was under lockdown, so year-over-year comparisons were relatively easy.  On a quarter-over-quarter basis, GDP rose by a hardly robust 0.8%.  There are reasonable doubts about the health of the much-anticipated Chinese economic recovery and concerns about deflation taking root. 

Combine those with what appears to be a reluctance by Beijing to engage in aggressive stimulus, and we had the basis for a 1% selloff in Europe.  Luxury goods manufacturers like LVMH have been leaders among Continental shares, so it is reasonable for those stocks to act poorly amidst concerns that Chinese consumers might not be as willing or able to extend themselves as much as hoped.  The Euro Stoxx 50 traded down about 1%, led lower by consumer discretionary stocks along with ASML.  

US futures traded lower for much of the pre-market, but then the usual trading patterns took hold.  Around 8:00 EDT, as has become somewhat typical, buyers showed up.  It’s not clear that there needs to be any reason for a bounce in pre-opening futures trading, just the belief that some other buyers will present themselves around the market open.  And so far this morning, the buyers have shown up.  Not in force, per se, but enough to create an initial bounce and then another modest leg higher after those pesky Europeans have called it a day.  (To be fair, buried in today’s better-than-expected Empire index report was a measure that showed falling prices.  But it’s been my experience that the Empire index is rarely a catalyst.  It’s only invoked when it can be used to explain what’s already occurring in the market.)

This is exactly what I meant when I referred to the US market as an inertial market, as opposed to a momentum market.  Investors frequently discuss momentum-driven strategies, but I believe that we are seeing something more basic.  Newton’s First Law of Motion roughly states that a body in motion tends to stay in motion until acted upon by an external force.  On a macro level, the US equity market has been in an uptrend for the past few months, ever since we averted a banking crisis that had the side effect of reversing months of quantitative tightening. 

On a micro level, if a certain type of behavior seems to work more often than not, then traders will repeat it until it definitively stops working.  If it is profitable to buy futures before the market opens, then traders will do so.  If it is profitable to buy stocks on the market open, then they will do that too.  And if it is profitable to buy US stocks around the European close, then why expect otherwise.  The behavior stays in place until or unless it repeatedly becomes unprofitable.  And that is unlikely to occur until or unless some external force disrupts the inertia.

As of this morning, at least, economic malaise in China was not a substantial enough force to disrupt US market inertia.  Never mind that it was Chinese expansion that helped pull the world out of the global financial crisis, nor that China-focused globalization was a key force in keeping global inflation in check for over a decade.  Let’s also put aside that a solid Chinese post-Covid economy was supposed to be a key factor boosting multinational companies’ profits and a key element in enabling a soft landing or even a “no landing” scenario.  Why should stuff going on halfway around the world disrupt the trading patterns that have been working so well in US markets recently?

We should learn more about whether we need to be concerned about conditions beyond our borders over the coming weeks as second-quarter earnings roll out.  Once we get beyond the largest banks, which I’ve long asserted can be a very poor bellwether for the reports to follow, we will learn if corporate managements consider global macroeconomic trends – including those from China – to be a headwind. 

Remember, we have seen considerable multiple expansion since last quarter’s earnings season.  In early April the S&P 500 Index traded at a 19.5 P/E on a trailing basis and 18.75 on a forward basis according to Bloomberg estimates.  As of last week, those have increased to 21.56 and 20.8 respectively.  Noting that they rose by almost exactly the same amount, we can assert that the market’s gains were simply the result of investors’ willingness to pay more for the same amount of earnings, rather than earnings expectations outpacing that willingness.

Does that raise the hurdle for the coming weeks?  One might think so.  After a solid run like we’ve seen, it is possible that “in-line” might not be good enough, and that loftier prices raise the risk of disappointment.  Earnings season could indeed be the type of force significant enough to disrupt the US equity market’s formidable inertia.  But then again, the last truly disruptive force (March’s banking crisis) proved to be an unintended catalyst.