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Fundamental Drivers of the Stock Market Correction

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Thursday,September 24, 2015
Money and Markets
Fundamental Drivers of the Stock Market Correction
by Mike Burnick

Dear ,

Mike Burnick

After plunging 12% peak to trough at the August low, the S&P 500 managed to bounce 8.2% higher before rolling over again post-Fed. The selling accelerated to the downside yesterday, focusing the attention of investors on a possible retest of the 1,867 low for the S&P, and whether or not it will hold.

To help answer that question, let's take a closer look at the fundamental drivers behind the stock market correction and the next catalyst, which is just a few weeks away.

The S&P 500 has actually held up pretty well compared to many international stock markets. U.S. stocks were locked in a narrow trading range for over six months before the correction got underway in August. Meanwhile, many emerging markets were already down sharply.

The reason for this divergence has everything to do with deflation, which is the key fundamental driver behind the global stock market decline.

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First, industrial commodity prices have been plunging since 2011, with crude oil down 52% from its peak while copper prices have sunk 48%. This is a surefire sign of global deflation, and it hits emerging market economies particularly hard.

That's why the global slowdown showed up first in emerging markets, but since today's world economy is more tightly integrated than ever before, it didn't take long to spill over into already slow-growing developed markets.

While it's true that U.S. exports to emerging markets make up less than 5% of our GDP, emerging market economies as a whole account for 57% of world GDP growth! Weakness in emerging market leads to a slowdown in global trade, which has a negative impact on all our trading partners, especially Europe and Japan.

The strong dollar over the past year has intensified deflationary pressures worldwide and magnified the slowdown in global trade.

Click image for larger view

You can see this relationship most clearly in the chart above. Persistent weakness in the U.S. Producer Price Index (blue line) signals intensifying deflation.

And the PPI has a very high correlation with U.S. business sales (black line), which are also being dragged lower along with U.S. corporate profit margins.

And that's where the stock market correction comes in.

Top line sales for S&P 500 companies are on track to decline 2.3% in 2015 and are forecast to fall 2.9% in the third quarter, according to FactSet estimates, while S&P 500 earnings are expected to decline 4.4%.

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S&P 500 sales have been declining for three straight quarters and this quarter marks the first back-to-back profit decline since 2009! So it's no wonder why investors are nervous about stock market valuations — the P part of the P/E ratio — when sales and profit margins are declining.

Declining corporate sales and profits are feeding back into lower U.S. GDP growth estimates. In fact, there is a growing gap between how well economists think the U.S. is growing and what the real-time data is saying.

The Federal Reserve Bank of Atlanta produces a forecast called GDPNow, which is based on 13 real-time economic indicators including housing starts, retail sales, durable goods purchases and more.

Click image for larger view

The current GDPNow forecast (see chart above) calls for real GDP growth of just 1.5% this quarter; that's a big disconnect compared to the "official" Blue Chip economists' consensus estimate of 2% growth.

Earlier this year, the real-time GDPNow estimate proved to be much closer to the mark than professional economists when the indicator accurately forecast flat first-quarter GDP growth. If it's proven right again this time, markets are in for a big disappointment when third-quarter preliminary GDP data is released next month.

So what does this mean for the stock market?

  1. Deflation and the strong dollar have conspired to pull the rug out from under global growth which is hurting corporate sales and profits.

  2. The stock market correction is all about uncertainty over slowing economic growth and falling profit margins, which are the fundamental foundation of stock market valuation.

Will the economy go into recession, and have profit margins peaked? These are the questions investors are wrestling with right now and stocks are likely to remain turbulent until we find the answers.

Over the next several weeks, we'll get the latest round of corporate sales and profit results. And next month we'll find out about U.S. third quarter GDP growth. Stay tuned.

Good investing,

Mike Burnick

The investment strategy and opinions expressed in this article are those of the author's and do not necessarily reflect those of any other editor at Weiss Research or the company as a whole.

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