The Cake is Baked. So What’s the Icing?
We’ve been postulating for weeks now that the mid-term elections have already been discounted by the equity markets. That is, the equity markets’ 12+% rise from their late August bottom has been due, in part, to expectations of a Republican retake of the majority vote in the House of Representatives. But election euphoria alone hasn’t done all the work--the other factor contributing to the markets’ rise, we have been proposing, has been the expectation of the initiation of QE2 in November and that, therefore, is also discounted to some degree. In fact, these two “events” have been the principal drivers of this market now for almost two months, all in the face of continued weak economic data. Expectations for the mid-terms probably got it all started and QE2, which has brought the US Dollar to a 15 year low versus most major currencies, has been doing the heavy lifting, acting as the support and continuing driver to equities. In fact, the US market indices now slavishly move in reverse lockstep to the dollar’s strength or weakness, ignoring economic data, earnings reports, or any other fundamental data related to their constituent companies. So, with the two big catalysts already baked into the cake, so to speak, what’s left to drive the equity markets to the end of the year?
According to our research, gleaned from multiple sources, since 1922 the average fourth quarter rise in the Dow in a mid-term election year is 8.5%. In fact, there were only two times when the equity markets were not higher in the 90 days following a mid-term election and in both situations the Fed was actively raising rates in an attempt to reign in the economy. Given October’s performance to date, we’re already half way to the average. But this has been a year of historic swings—worst May since the 50’s, best September since the 30’s, etc. etc. Have we already gotten half the expected gains for Q4? We don’t think so. There are several drivers still remaining, which have not been fully discounted by the markets. The first is a Republican retake of the Senate as well. Polls are notoriously inaccurate but many show this as a possibility. Would it drive stocks higher? We think so. In fact, we are beginning to believe that political “gridlock,” usually so good for the markets, may be a detriment this time around. Much of what has been suppressing the economy, and thus the markets, over the last year-and-a-half have been the onerous bills passed by the current Congress—Health Care and Financial Reform. With gridlock, these two items will most likely persist, unmodified. With a Republican mandate in both the House and Senate, there is a fair chance that they will be lightened up to the benefit of business or, better yet, go away altogether.
Another driver we see is the size of QE2. Right now it is difficult to find a portfolio manager appearing on TV who doesn’t believe that QE2 will be anything less than $1Trillion but there are still some skeptics. We think the Fed is listening and doesn’t wish to rock the equity markets, which it is attempting to lift to spur the wealth effect. Therefore, we believe that the minimum amount of the easing will be $1trillion. Anything more and the dollar will plummet further, with the markets off to the races.
Finally, there is—gasp--fundamentals and valuation. Does anyone pay attention to those anymore? We think investors will start doing so again, particularly if the “government overhang” is eliminated in the mid-terms. Right now First Call is looking for $92+ in S&P500 earnings for 2011—that’s a 14% rise from this year’s estimates, ¾ of which are “in the bag” with the remaining quarters inching higher as this earnings season progresses. That puts the S&P at 12.8x forward earnings, a decade low. And with those earnings estimates poised to rise with renewed confidence and guidance from Company Management (again, post elections), we may well see a market that not only grows along with earnings (just like the good old days) but gets some long awaited multiple expansion. Given this and the “icings’ mentioned above, we believe Q4 and 2011 will be sweet for equity investors indeed.
Tuesday, October 26, 2010
Monday, October 18, 2010
Ramblings of a Portfolio Manager
The QE2 is Setting Sail to New York. So Why Were All The Passengers Wearing Sombreros and Blowing Didgeridoos?
Ben Bernanke gave his much anticipated speech regarding the Fed’s propensity to reinitiate Quantitative Easing at an FOMC-sponsored Conference in Boston last Friday. The speech was intended to give insight into the probabilities of the FOMC announcing a resumption of Quantitative Easing (dubbed QE2) at its November meeting. In his remarks, Bernanke said inflation is currently too low and the unemployment rate is too high given the central bank’s dual mandate of maximum economic growth and price stability: He made a case for new Fed action to boost growth, saying inflation is running below the Fed's objective of 2% and that the economy is growing too slowly to reduce unemployment. But he also cautioned that there were costs associated with the policy as well as benefits and the Fed had much less experience in judging the economic effects of asset purchases, “which makes it challenging to determine the appropriate quantity and pace of purchases and to communicate this policy response to the public.” He went on to say that “These factors have dictated that the FOMC proceed with some caution in deciding whether to engage in further purchases of longer-term securities.” “Even though the conditions are in place for growth to pick up next year,” he said, “high unemployment and low inflation will probably linger.” “Given the FOMC’s objectives, there would appear -- all else being equal -- to be a case for further action.” Sometimes, around here, we miss the cryptic ramblings of Alan Greenspan. At least, under all that enigmatic Fed Speak, there was a definitive answer to the Fed’s next course of action. One just needed his Captain America decoder ring and a Cray XT-3 with language processing software and all was clear.
There was much economic data released on the day Bernanke spoke but the markets reacted almost solely to the Chairman’s words and the speech was greeted with little more than a yawn by the equity markets. Initially it gave a mild boost to equities and took some of the steam out of Gold. But Bernanke said very little that the markets were not already anticipating--since the Chairman outlined the potential second round of quantitative easing during an Aug. 27 speech in Jackson Hole, global equities have climbed 14.1% and commodities have gained 13.1%--and by the end of the day most equity markets were down and Gold had recovered some of its losses. The dollar, however, turned higher against the Euro and a basket of major currencies, but was still down broadly for the week. The interesting price action came in the 30-year Treasury bond where the bonds slumped, driving the yield up 18 basis points to just under 4.0% for the week. That’s a big jump in long rates from their September lows in the 3.5% range. Why the seemingly perverse reaction to an announcement by the Chairman of the FOMC that the Federal Reserve would begin a program of attempting to hold down long-term rates for a very long time?
We have been tracking street expectations for QE2 since the initial announcement in August. Since the markets began to digest that the Federal Reserve was serious in its plans, expectations for the timing and size of the operation have continually grown. By our analysis, there is now little market doubt that the FOMC will launch QE2 at the November meeting. Expectations range from $500 Billion to a $1 Trillion program, with some as high as $1.5 Trillion. Such a large disparity of viewpoints is a clear indication that the FOMC has done a poor job communicating its policies and managing market expectations. In fact, the way we see it, the FOMC has probably let expectations run too high and has created a situation where the current actions we have seen in financial markets are being driven almost entirely by QE2 expectations. The Fed, in essence, have painted themselves into a corner whereby there will be a negative reaction in equities, currencies and bonds if the markets’ expectations are not met.
So what will be the size of QE2 and will it work? Bernanke called the first purchases of $1.7 trillion in mostly housing-related assets successful. There are a range of opinions on the FOMC about the method of further asset purchases, and the details will be hashed out at the FOMC’s next meeting on Nov. 2-3. The market’s focus, however, will be “how much?” From our work it would appear anything short of $1.0 Trillion in QE2 would disappoint both equity and currency watchers.
But the markets’ trepidations go beyond the final amount of the QE2. The big fear, for many experienced investors, is whether the Fed will have an adequate exit strategy and will they time it properly—i.e. will their program work too well and ignite hyperinflation before they can shut it down. That’s why bonds sold off and the dollar strengthened on Bernanke’s speech, in our opinion. The Chairman’s response was that he is confident the Fed will be able to tighten policy when warranted, even if the balance sheet is larger than normal but he also pointed out that the FOMC might consider modifying the language of its policy statement to indicate that it will keep rates “low for longer than markets expect.” At the moment, the FOMC statement is that the exceptionally low levels of the federal funds rate are likely to be warranted “for an extended period.” Remember, the target is to get inflation higher and Ben Bernanke, student of the depression, will not be the Fed Chairman who presides over a US economy in depression and with deflation if he can avoid it. So in addition to preventing deflation, we believe QE2 is intended to boost equity prices and thus, net worth and the economy in general. The question is, will the Fed cave into market expectations and target the $1.0 Trillion number?
We expect the Fed to hit the $1 Trillion number but for the perverse reaction to QE2 to continue. That is, we expect long-term rates to rise and the dollar strengthen even as the Fed begins its purchases. Why? First of all, as we noted, the markets have already priced in a significant size of QE2; long treasuries are almost certainly discounting the $1.0 Trillion number so probably don’t have much more to rise. Secondly, as the Fed injects more liquidity into the capital markets stocks will most likely rise, adding to the wealth effect. This, combined with potential strengthening confidence in the economy post mid-terms, will serve to steepen the yield curve by raising the long end, even the face of Fed purchases (its almost impossible to steepen the curve by dropping short-term rates, which are essentially zero). Finally, most missed it but Bernanke raised the Fed’s expectations for US economic growth next year. If our scenario and theirs is correct, it all points to risk in holding US fixed income securities and a rosy future for US equities. We don’t know much about them but if you’re looking to invest in fixed income, you might look toward the countries nearing the end of their tightening cycles—Brazil and Australia. Happy sailing!
Ben Bernanke gave his much anticipated speech regarding the Fed’s propensity to reinitiate Quantitative Easing at an FOMC-sponsored Conference in Boston last Friday. The speech was intended to give insight into the probabilities of the FOMC announcing a resumption of Quantitative Easing (dubbed QE2) at its November meeting. In his remarks, Bernanke said inflation is currently too low and the unemployment rate is too high given the central bank’s dual mandate of maximum economic growth and price stability: He made a case for new Fed action to boost growth, saying inflation is running below the Fed's objective of 2% and that the economy is growing too slowly to reduce unemployment. But he also cautioned that there were costs associated with the policy as well as benefits and the Fed had much less experience in judging the economic effects of asset purchases, “which makes it challenging to determine the appropriate quantity and pace of purchases and to communicate this policy response to the public.” He went on to say that “These factors have dictated that the FOMC proceed with some caution in deciding whether to engage in further purchases of longer-term securities.” “Even though the conditions are in place for growth to pick up next year,” he said, “high unemployment and low inflation will probably linger.” “Given the FOMC’s objectives, there would appear -- all else being equal -- to be a case for further action.” Sometimes, around here, we miss the cryptic ramblings of Alan Greenspan. At least, under all that enigmatic Fed Speak, there was a definitive answer to the Fed’s next course of action. One just needed his Captain America decoder ring and a Cray XT-3 with language processing software and all was clear.
There was much economic data released on the day Bernanke spoke but the markets reacted almost solely to the Chairman’s words and the speech was greeted with little more than a yawn by the equity markets. Initially it gave a mild boost to equities and took some of the steam out of Gold. But Bernanke said very little that the markets were not already anticipating--since the Chairman outlined the potential second round of quantitative easing during an Aug. 27 speech in Jackson Hole, global equities have climbed 14.1% and commodities have gained 13.1%--and by the end of the day most equity markets were down and Gold had recovered some of its losses. The dollar, however, turned higher against the Euro and a basket of major currencies, but was still down broadly for the week. The interesting price action came in the 30-year Treasury bond where the bonds slumped, driving the yield up 18 basis points to just under 4.0% for the week. That’s a big jump in long rates from their September lows in the 3.5% range. Why the seemingly perverse reaction to an announcement by the Chairman of the FOMC that the Federal Reserve would begin a program of attempting to hold down long-term rates for a very long time?
We have been tracking street expectations for QE2 since the initial announcement in August. Since the markets began to digest that the Federal Reserve was serious in its plans, expectations for the timing and size of the operation have continually grown. By our analysis, there is now little market doubt that the FOMC will launch QE2 at the November meeting. Expectations range from $500 Billion to a $1 Trillion program, with some as high as $1.5 Trillion. Such a large disparity of viewpoints is a clear indication that the FOMC has done a poor job communicating its policies and managing market expectations. In fact, the way we see it, the FOMC has probably let expectations run too high and has created a situation where the current actions we have seen in financial markets are being driven almost entirely by QE2 expectations. The Fed, in essence, have painted themselves into a corner whereby there will be a negative reaction in equities, currencies and bonds if the markets’ expectations are not met.
So what will be the size of QE2 and will it work? Bernanke called the first purchases of $1.7 trillion in mostly housing-related assets successful. There are a range of opinions on the FOMC about the method of further asset purchases, and the details will be hashed out at the FOMC’s next meeting on Nov. 2-3. The market’s focus, however, will be “how much?” From our work it would appear anything short of $1.0 Trillion in QE2 would disappoint both equity and currency watchers.
But the markets’ trepidations go beyond the final amount of the QE2. The big fear, for many experienced investors, is whether the Fed will have an adequate exit strategy and will they time it properly—i.e. will their program work too well and ignite hyperinflation before they can shut it down. That’s why bonds sold off and the dollar strengthened on Bernanke’s speech, in our opinion. The Chairman’s response was that he is confident the Fed will be able to tighten policy when warranted, even if the balance sheet is larger than normal but he also pointed out that the FOMC might consider modifying the language of its policy statement to indicate that it will keep rates “low for longer than markets expect.” At the moment, the FOMC statement is that the exceptionally low levels of the federal funds rate are likely to be warranted “for an extended period.” Remember, the target is to get inflation higher and Ben Bernanke, student of the depression, will not be the Fed Chairman who presides over a US economy in depression and with deflation if he can avoid it. So in addition to preventing deflation, we believe QE2 is intended to boost equity prices and thus, net worth and the economy in general. The question is, will the Fed cave into market expectations and target the $1.0 Trillion number?
We expect the Fed to hit the $1 Trillion number but for the perverse reaction to QE2 to continue. That is, we expect long-term rates to rise and the dollar strengthen even as the Fed begins its purchases. Why? First of all, as we noted, the markets have already priced in a significant size of QE2; long treasuries are almost certainly discounting the $1.0 Trillion number so probably don’t have much more to rise. Secondly, as the Fed injects more liquidity into the capital markets stocks will most likely rise, adding to the wealth effect. This, combined with potential strengthening confidence in the economy post mid-terms, will serve to steepen the yield curve by raising the long end, even the face of Fed purchases (its almost impossible to steepen the curve by dropping short-term rates, which are essentially zero). Finally, most missed it but Bernanke raised the Fed’s expectations for US economic growth next year. If our scenario and theirs is correct, it all points to risk in holding US fixed income securities and a rosy future for US equities. We don’t know much about them but if you’re looking to invest in fixed income, you might look toward the countries nearing the end of their tightening cycles—Brazil and Australia. Happy sailing!
Monday, October 4, 2010
Ramblings of a Portfolio Manager
Will Santa Deliver an Early Christmas Present or Will a Turkey Fall Down the Chimney?
Earnings season officially kicked off last week with the turn of the calendar, although we have already heard pre-announcements from several companies. As has been the tradition for years now, the preannouncements came ahead of the regular reporting season (by definition, duh!) and carried no particular good news—Company Management has long been cowed by litigation to release the bad news as soon as it is discovered and accurately calculated, lest they be sued for of hiding it from shareholders. So the routine, for a long time now, has been for the markets to receive the bad news first, react to that bad news (usually a negative reaction—after 15 years of Reg FD most investors still haven’t figured out this pattern!), then have the comprehensive news follow during the regular reporting season. Typically that data is better than the preannouncements (again, definitionally) and the markets react to that data depending upon its current mood. That’s certainly what happened last quarter.
We expect nothing different behaviorally for the third quarter reporting season vis-a-vis past trends. The questions, as always, are, what percentage of the reports will be negative pre-announcements, how many will match recent the urban myth of “light on revenues, better on bottom line” and what percentage will actually surpass all metrics pre-cast by the analysts? Yes, this is the question we and the markets ask every quarter, particularly since the market bottom in March 2009, but forgive us for asking it again, given its importance in market performance going forward. And besides, we wanted to get it in ahead of CNBC, which will repeat these lines at least 1543 times between now and November 15th, as always, forgetting that retailers’ reports come one month later.
So what to expect when you are expecting (royalties already paid to the baby book authors)? First, let’s explore what the few market watchers that have publicly spoken on the subject have been saying. Despite better than expected reported statistics and higher than expected guidance last quarter (which did nothing more than temporary for the markets) analysts are still calling for earnings misses and weaker guidance. Their reasoning? Q3 encompassed July and August, two critical months in the European debt crisis and the US ”soft spot.” So, naturally, the expectation is for weak results (perhaps weather than forecast) with soggy guidance (don’t they get that they, themselves, have already baked that fact into their numbers? Guess not). Sounds exactly like the forecast for Q2 earnings, the reality of which stubbornly didn’t comply. Is that how it will be again this time ‘round? And what will be the market reaction? Addressing the first question, we think not. As we have continually stressed, Company Management has learned from years of playing the “beat and raise” game to lower the bar to an appropriate level that can be easily hurdled without seeming suspicious. Nothing we heard last earnings season suggests that we will get anything different this time around—despite the beat and raise environment we had in Q2. No manager on a Q2 conference call was about to stick his neck out given the environment at the time so we feel confident that this fact, combined with the usual conservative game theory behavior in which managers quarterly participate, will produce yet another round of 70%+ earnings beats, given that analysts simply take Management numbers to form their own forecasts. What about guidance? Here again, we expect the same. In fact, the Company Management with whom we have spoken recently are getting more optimistic in light of expected mid-term regime change and may, in fact, be emboldened enough to say even more positive things about Q4 and beyond, especially on the hiring front—and this is despite the political affiliation of the manager (we always ask).
Market reaction? We’re tempted to flippantly (pun intended) suggest one “flip a coin.” Even though the expectations are for weak reports and guidance, the opposite may not have the expected reaction in equity prices. They didn’t, on net, during Q2 (July having been taken back in August) so what has changed that will produce a different result in October? Well, for one thing, the [very] long term data suggest that better than expected earnings reports and guidance produce stock price gains overall and alpha specifically for those companies producing it. A couple of quarters during which the markets are in a sour mood and choose to ignore that fact are statistically insignificant. This doesn’t mean October will fall in line with history, however. What we believe will give the markets a boost on better earnings in the next few months is rising investor optimism. When Q2 earnings were reported in July, investor sentiment could not have been worse and even though we got a temporary run in stock prices, the tug-of-war with macro economic data ended with macro winning and tamping down the enthusiasm and, thus, stock prices. But this quarter is different. We have investors looking optimistically toward the upcoming elections, others looking at their underperformance and realizing that further investments in 10-year Treasuries just aint gonna beat the competition, and still others looking at 2011 as the year Obama’s damage is softened by a new congress while the economy continues to heal on its own. Like us, this last group has seen productivity gains slow and capacity utilization additional reach cap-ex levels, and both recognize this means jobs and further economic growth down the road.
So, to answer our own headline question, we thing Santa comes early this year and that the turkeys will be sucking gravy come earnings season.
Earnings season officially kicked off last week with the turn of the calendar, although we have already heard pre-announcements from several companies. As has been the tradition for years now, the preannouncements came ahead of the regular reporting season (by definition, duh!) and carried no particular good news—Company Management has long been cowed by litigation to release the bad news as soon as it is discovered and accurately calculated, lest they be sued for of hiding it from shareholders. So the routine, for a long time now, has been for the markets to receive the bad news first, react to that bad news (usually a negative reaction—after 15 years of Reg FD most investors still haven’t figured out this pattern!), then have the comprehensive news follow during the regular reporting season. Typically that data is better than the preannouncements (again, definitionally) and the markets react to that data depending upon its current mood. That’s certainly what happened last quarter.
We expect nothing different behaviorally for the third quarter reporting season vis-a-vis past trends. The questions, as always, are, what percentage of the reports will be negative pre-announcements, how many will match recent the urban myth of “light on revenues, better on bottom line” and what percentage will actually surpass all metrics pre-cast by the analysts? Yes, this is the question we and the markets ask every quarter, particularly since the market bottom in March 2009, but forgive us for asking it again, given its importance in market performance going forward. And besides, we wanted to get it in ahead of CNBC, which will repeat these lines at least 1543 times between now and November 15th, as always, forgetting that retailers’ reports come one month later.
So what to expect when you are expecting (royalties already paid to the baby book authors)? First, let’s explore what the few market watchers that have publicly spoken on the subject have been saying. Despite better than expected reported statistics and higher than expected guidance last quarter (which did nothing more than temporary for the markets) analysts are still calling for earnings misses and weaker guidance. Their reasoning? Q3 encompassed July and August, two critical months in the European debt crisis and the US ”soft spot.” So, naturally, the expectation is for weak results (perhaps weather than forecast) with soggy guidance (don’t they get that they, themselves, have already baked that fact into their numbers? Guess not). Sounds exactly like the forecast for Q2 earnings, the reality of which stubbornly didn’t comply. Is that how it will be again this time ‘round? And what will be the market reaction? Addressing the first question, we think not. As we have continually stressed, Company Management has learned from years of playing the “beat and raise” game to lower the bar to an appropriate level that can be easily hurdled without seeming suspicious. Nothing we heard last earnings season suggests that we will get anything different this time around—despite the beat and raise environment we had in Q2. No manager on a Q2 conference call was about to stick his neck out given the environment at the time so we feel confident that this fact, combined with the usual conservative game theory behavior in which managers quarterly participate, will produce yet another round of 70%+ earnings beats, given that analysts simply take Management numbers to form their own forecasts. What about guidance? Here again, we expect the same. In fact, the Company Management with whom we have spoken recently are getting more optimistic in light of expected mid-term regime change and may, in fact, be emboldened enough to say even more positive things about Q4 and beyond, especially on the hiring front—and this is despite the political affiliation of the manager (we always ask).
Market reaction? We’re tempted to flippantly (pun intended) suggest one “flip a coin.” Even though the expectations are for weak reports and guidance, the opposite may not have the expected reaction in equity prices. They didn’t, on net, during Q2 (July having been taken back in August) so what has changed that will produce a different result in October? Well, for one thing, the [very] long term data suggest that better than expected earnings reports and guidance produce stock price gains overall and alpha specifically for those companies producing it. A couple of quarters during which the markets are in a sour mood and choose to ignore that fact are statistically insignificant. This doesn’t mean October will fall in line with history, however. What we believe will give the markets a boost on better earnings in the next few months is rising investor optimism. When Q2 earnings were reported in July, investor sentiment could not have been worse and even though we got a temporary run in stock prices, the tug-of-war with macro economic data ended with macro winning and tamping down the enthusiasm and, thus, stock prices. But this quarter is different. We have investors looking optimistically toward the upcoming elections, others looking at their underperformance and realizing that further investments in 10-year Treasuries just aint gonna beat the competition, and still others looking at 2011 as the year Obama’s damage is softened by a new congress while the economy continues to heal on its own. Like us, this last group has seen productivity gains slow and capacity utilization additional reach cap-ex levels, and both recognize this means jobs and further economic growth down the road.
So, to answer our own headline question, we thing Santa comes early this year and that the turkeys will be sucking gravy come earnings season.
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