Ramblings of a Portfolio Manager--The Perfect Trifecta?
It should be no news to investors that, since July, the US capital markets have been held hostage by political and economic events unfolding in Europe. One cannot pick up a publication above a child’s pop-up book without reading about the political machinations in Greece and Italy and the struggles of French and German ministers, along with the ECB and IMF, to staunch the tide of debt defaults and ensuing continental recession. And our markets seem to move dramatically on every utterance by any European “official” however minor. For nearly 4 months now, the US capital markets have been the dog wagged by the Euro-tail. In fact, a recent study showed a 70+% correlation between US and European equities, nearly twice the long-run average. Should this be and how long can the trend continue? We see three reasons why the trend may be soon to end.
We are now at the tail end of earnings season in the US. Remember, this was a very low expectations season as many analysts had factored in the “Euro effect” into their numbers. Estimates were that 2011 S&P earnings could drop by as much as 25%, especially given that the depths of the European crisis occurred largely in the third quarter. Instead, US companies continued their long run of beating estimates with over 75% of companies doing so, right in line with the trend for the last eight quarters. S&P earnings estimates for the year barely budged. And as far as forward guidance from Management, it was not so robust as in past quarters, given the uncertainty in Europe, however 2012 S&P earnings have been revised down less than 3%. Hardly the stuff of economic Armageddon that has been predicted. In fact, the S&P500 is now trading at over 3 multiple points below its long run average. Yet this past season was the least talked about earnings reporting period probably in history as the financial press focused all their attention on Europe. Had Europe not existed, equity markets in this country would surely be much higher just on the back of earnings alone.
Also largely ignored by the talking heads was China. For over a year now economists have been wringing their hands over China’s monetary tightening policy, aimed at curtailing the real estate boom in that country. The fear was that China could not engineer a soft landing in the broader economy and would slip into recession, dragging the rest of the world with it. In the last few weeks, however, we’ve received data out of China that their braking efforts have been effective with inflation slowing while the economy continued expansion at a fairly robust pace. In fact, the Chinese have now stopped their string of interest rate and reserve hikes, signaling an end to their tightening policy and there is now talk of reducing the reserve requirements on banks, clearly an easing move. In fact, data shows that Chinese bank lending has risen substantially over the last two months, a sign that banks, at least, believe that the tightening cycle is at an end and a period of easing may lie ahead. Of course, that would good for world economies and, by proxy, world equity markets.
Finally, though the doomsayers may posit otherwise, the Europeans are, in fact, moving aggressively to fix their problems. No, with 17 sovereign entities to work in harmony, they cannot implement changes as fast as we did TARP in this country but it is clear that France and Germany are taking the lead to move things ahead. Does anyone doubt that Merkel and Sarkozy pulled a Luca Brazi on the Greek Prime Minister over the referendum? You can bet they will do that with Berlusconi as well if needed. While the issues in Europe will be worked out over months if not years, eventually they will fade from the front pages. That factor, along with China easing and record low interest rates and P/Es in this country, could just be the perfect trifecta for a significant market rally.
Monday, November 7, 2011
Monday, August 22, 2011
Ramblings of a Portfolio Manager
What to Expect From Jackson Hole
This Friday Chairman Ben Bernanke will speak at the Federal Reserve’s annual symposium in Jackson Hole, Wyoming.
Last year, Bernanke hinted that the Fed might embark on a second round of asset purchases to bolster the recovery, dubbed QE2. That speech kicked off a 28 percent rally in the Standard & Poor’s 500 Index of stocks that ended in a three-year high on April 29th.
At the last Fed meeting policy makers pledged to keep their benchmark interest rate near zero until at least mid-2013 and also said they “discussed the range of policy tools” available, giving hope that they may add to their record stimulus. That signaled that a QE3 might be on the table.
The whole world will be watching Bernanke’s speech, so if he chooses not to say very much, the global markets are sure to be disappointed. Though many market observers deny we will get a QE3, still there is hope among many that one will be forthcoming in some form.
Predictions are that Bernanke will suggest that the central bank will lengthen the average maturity for its $2.86 trillion of assets, which would help bring down long-term interest rates. The yield on the benchmark 10-year Treasury note dropped as low as 2.062 percent on Aug. 19 in New York, according to Bloomberg Bond Trader prices. Yields have fallen to record lows since the Fed announced its rate pledge on Aug. 9.
At the Fed’s last meeting Federal Reserve Bank presidents Charles Plosser of Philadelphia, Richard Fisher of Dallas and Narayana Kocherlakota of Minneapolis all voted against the Fed’s decision to keep the target for the federal funds rate at zero to 0.25 percent until at least mid-2013. Plosser and Fisher both said last week the pledge won’t help spur growth. The last time three policy makers dissented was in November 1992.
The central bank has kept the rate on overnight loans among banks near zero since December 2008. It also purchased $1.7 trillion of Treasury and mortgage debt between December 2008 and March 2010, and the $600 billion of Treasuries from November through June. The result was a temporary rise in risk assets but economic growth and job creation remains moribund.
Despite what many market watchers believe, the Fed is not out of bullets yet. Bernanke told Congress on July 13 the Fed does have stimulus options; these include buying additional securities, increasing the average maturity of its bond portfolio, lowering the interest rate on excess reserves and pledging to keep its balance sheet near a record high for a longer period of time.
When he foreshadowed the Federal Open Market Committee’s Aug. 9 decision to hold interest rates near record lows, the S&P 500 Index climbed 7.6 percent between Aug. 8 and Aug. 15. Unfortunately, it has since fallen 6.7 percent since amid concerns that U.S and global economic growth are faltering. Still, the Fed got a pretty good response to its decision, so they may deploy one or more of their remaining tricks.
The bond market seems to be already is pricing in an expectation that the Fed will announce new purchases of $500 billion to $600 billion, and investors looking for confirmation in Bernanke’s Jackson Hole speech may be disappointed.
The cost of living in the U.S. accelerated at an annual pace of 1.8 percent in July, excluding food and energy costs, which are typically more volatile. The gain was the largest in more than a year, according to Labor Department data released Aug. 18. That signals that, at least, QE2 was successful in staving off deflation.
However, the economy grew at a weaker-than-projected 1.3 percent annual pace in the second quarter, the Commerce Department said July 29, and growth in the prior quarter slowed to 0.4 percent, the weakest three-month period since the recovery began June 2009, suggesting that QE2 did little for the economy.
Morgan Stanley analysts have cut their estimate for expansion worldwide this year to 3.9 percent from a previous prediction of 4.2 percent. Part of the reason was “the drama” around lifting the U.S. debt ceiling, which helped depress financial markets and erode business and consumer confidence, the analysts said in a report last week.
Bernanke would have to overcome internal opposition to additional measures after his rate pledge led to the three dissents. There is less agreement this year among FOMC members that further easing is needed than there was a year ago when Bernanke spoke out. That suggests that the Fed chairman won’t hint at additional measures in Jackson Hole.
Still, Bernanke’s has shown he is willing to swim against the tide of dissent among the Governors in his decision to pursue the rate pledge with or without the full support of his fellow policy makers. So we the markets may get some, even if little comfort, this week.
This Friday Chairman Ben Bernanke will speak at the Federal Reserve’s annual symposium in Jackson Hole, Wyoming.
Last year, Bernanke hinted that the Fed might embark on a second round of asset purchases to bolster the recovery, dubbed QE2. That speech kicked off a 28 percent rally in the Standard & Poor’s 500 Index of stocks that ended in a three-year high on April 29th.
At the last Fed meeting policy makers pledged to keep their benchmark interest rate near zero until at least mid-2013 and also said they “discussed the range of policy tools” available, giving hope that they may add to their record stimulus. That signaled that a QE3 might be on the table.
The whole world will be watching Bernanke’s speech, so if he chooses not to say very much, the global markets are sure to be disappointed. Though many market observers deny we will get a QE3, still there is hope among many that one will be forthcoming in some form.
Predictions are that Bernanke will suggest that the central bank will lengthen the average maturity for its $2.86 trillion of assets, which would help bring down long-term interest rates. The yield on the benchmark 10-year Treasury note dropped as low as 2.062 percent on Aug. 19 in New York, according to Bloomberg Bond Trader prices. Yields have fallen to record lows since the Fed announced its rate pledge on Aug. 9.
At the Fed’s last meeting Federal Reserve Bank presidents Charles Plosser of Philadelphia, Richard Fisher of Dallas and Narayana Kocherlakota of Minneapolis all voted against the Fed’s decision to keep the target for the federal funds rate at zero to 0.25 percent until at least mid-2013. Plosser and Fisher both said last week the pledge won’t help spur growth. The last time three policy makers dissented was in November 1992.
The central bank has kept the rate on overnight loans among banks near zero since December 2008. It also purchased $1.7 trillion of Treasury and mortgage debt between December 2008 and March 2010, and the $600 billion of Treasuries from November through June. The result was a temporary rise in risk assets but economic growth and job creation remains moribund.
Despite what many market watchers believe, the Fed is not out of bullets yet. Bernanke told Congress on July 13 the Fed does have stimulus options; these include buying additional securities, increasing the average maturity of its bond portfolio, lowering the interest rate on excess reserves and pledging to keep its balance sheet near a record high for a longer period of time.
When he foreshadowed the Federal Open Market Committee’s Aug. 9 decision to hold interest rates near record lows, the S&P 500 Index climbed 7.6 percent between Aug. 8 and Aug. 15. Unfortunately, it has since fallen 6.7 percent since amid concerns that U.S and global economic growth are faltering. Still, the Fed got a pretty good response to its decision, so they may deploy one or more of their remaining tricks.
The bond market seems to be already is pricing in an expectation that the Fed will announce new purchases of $500 billion to $600 billion, and investors looking for confirmation in Bernanke’s Jackson Hole speech may be disappointed.
The cost of living in the U.S. accelerated at an annual pace of 1.8 percent in July, excluding food and energy costs, which are typically more volatile. The gain was the largest in more than a year, according to Labor Department data released Aug. 18. That signals that, at least, QE2 was successful in staving off deflation.
However, the economy grew at a weaker-than-projected 1.3 percent annual pace in the second quarter, the Commerce Department said July 29, and growth in the prior quarter slowed to 0.4 percent, the weakest three-month period since the recovery began June 2009, suggesting that QE2 did little for the economy.
Morgan Stanley analysts have cut their estimate for expansion worldwide this year to 3.9 percent from a previous prediction of 4.2 percent. Part of the reason was “the drama” around lifting the U.S. debt ceiling, which helped depress financial markets and erode business and consumer confidence, the analysts said in a report last week.
Bernanke would have to overcome internal opposition to additional measures after his rate pledge led to the three dissents. There is less agreement this year among FOMC members that further easing is needed than there was a year ago when Bernanke spoke out. That suggests that the Fed chairman won’t hint at additional measures in Jackson Hole.
Still, Bernanke’s has shown he is willing to swim against the tide of dissent among the Governors in his decision to pursue the rate pledge with or without the full support of his fellow policy makers. So we the markets may get some, even if little comfort, this week.
Monday, August 15, 2011
Ramblings of a Portfolio Manager
Ramblings of a Portfolio Manager—This is NOT 2008!
It feels awful out there…trust us, we know. We’ve cancelled all summer plans to remain in the office to mind this market even though with 500 point Dow swings it is difficult to know exactly what to do, if anything (we wonder why Obama and the EU leaders haven’t done the same, instead choosing to put lotion on each others’ backs in some exotic warm locale). With volatility like this it is easy to make a mistake so we monitor, take advantage of dislocations and try to understand where things are headed. For many investors, however, it's easy to draw parallels between this market and 2008 and there from comes the volatility we are seeing. We don’t believe this period in the worlds’ economies or markets is anything like 2008 (or 1974 for that matter) and there are a number of indicators that tell us otherwise.
For example, if we look at the 2Yr USD Swap Spread chart below Courtesy of Bloomberg (a measure of fear over the financial health of banks)– it is clear that professionals in the global credit markets (as opposed to the retail investor in the US Treasury markets) do not believe this is 2008 all over again. The current 2 year USD Swap Spread, which ballooned to nearly 170 bps in the fall 2008, still hovers at a slightly elevated 29bps—it’s hardly a blip in the chart. We aren’t even where we were at the end of 2010 in terms of fear regarding the financial system. Remember, 2008 was all about the fear of every US Financial Institution being insolvent and/or under-capitalized. And we did have real defaults... remember CIT? That was true credit risk.
At the moment what it appears is that we are dealing with is a global sovereign/currency crisis, which requires large-scale solutions: Eurozone fiscal unity; Chinese participation in the EFSF, etc. Of course, some economists are talking about the possibility of breaking up the Euro, however, even the Germans (who get almost 40% of their GDP from exports) are vitally aware of the implications of operating once again under the Deutsche Mark. If we do some overly simple math we see that Germany can easily lose as much as €300Bln in exports every year if that were to happen. Compare that to their current peripheral contribution to Europe? It makes it look like peanuts. In any case, if Greece, Portugal and Spain collapse; then Germany is already on the hook. And the there are the German, French, Italian banks -- no one wants to see this happen and they aren’t going to let it.
We hear rumors daily—for example, on Thursday some small unknown Chinese bank supposedly stopped doing business with SocGen—it was false and certainly benefitted the rumor monger as it dropped the futures 200 points alone in just 10 minutes (of course the futures recovered and we had a nice day—hope he/she lost his/her shirt)—but most of these are just plain false. Yet while many of these fears/rumors are unfounded, the volatility they create is not helping to improve trading liquidity. Furthermore, the liquidity that the Central Banks are pumping into the markets is losing its benefits as investors take it for granted. It is clear that the global economy is slowing, and risk is being re-priced. But that doesn’t mean one cannot make money in stocks. In fact, as we have all seen over the last 3 years, the pendulum can over swing both ways until sanity prevails. At the moment, we believe risk is being overpriced and will return to normal slowly but in short order.
The good news is that right now our markets are functioning: $10Bln in new corporate bonds priced last week alone as companies took advantage of negative real interest rates to clean up their balance sheets. That's an important data point. It means that investors still have cash to put to work and issuers can still come to market. It also means that Corporate America is getting healthier and while dislocations such as negative real rates can persist for a time, the bond markets and, most likely the equity markets, have overreacted and we are due for a reversal. This morning Japan reported much better than expected GDP. And we have only seen upward revisions to S&P 500 earnings projections since earnings season. No, this is not 2008 although it may feel like it. We suggest you turn off the financial news, enjoy your summer vacation and let the capital markets quiet down and sort themselves out. They always do—even post 2008.
It feels awful out there…trust us, we know. We’ve cancelled all summer plans to remain in the office to mind this market even though with 500 point Dow swings it is difficult to know exactly what to do, if anything (we wonder why Obama and the EU leaders haven’t done the same, instead choosing to put lotion on each others’ backs in some exotic warm locale). With volatility like this it is easy to make a mistake so we monitor, take advantage of dislocations and try to understand where things are headed. For many investors, however, it's easy to draw parallels between this market and 2008 and there from comes the volatility we are seeing. We don’t believe this period in the worlds’ economies or markets is anything like 2008 (or 1974 for that matter) and there are a number of indicators that tell us otherwise.
For example, if we look at the 2Yr USD Swap Spread chart below Courtesy of Bloomberg (a measure of fear over the financial health of banks)– it is clear that professionals in the global credit markets (as opposed to the retail investor in the US Treasury markets) do not believe this is 2008 all over again. The current 2 year USD Swap Spread, which ballooned to nearly 170 bps in the fall 2008, still hovers at a slightly elevated 29bps—it’s hardly a blip in the chart. We aren’t even where we were at the end of 2010 in terms of fear regarding the financial system. Remember, 2008 was all about the fear of every US Financial Institution being insolvent and/or under-capitalized. And we did have real defaults... remember CIT? That was true credit risk.
At the moment what it appears is that we are dealing with is a global sovereign/currency crisis, which requires large-scale solutions: Eurozone fiscal unity; Chinese participation in the EFSF, etc. Of course, some economists are talking about the possibility of breaking up the Euro, however, even the Germans (who get almost 40% of their GDP from exports) are vitally aware of the implications of operating once again under the Deutsche Mark. If we do some overly simple math we see that Germany can easily lose as much as €300Bln in exports every year if that were to happen. Compare that to their current peripheral contribution to Europe? It makes it look like peanuts. In any case, if Greece, Portugal and Spain collapse; then Germany is already on the hook. And the there are the German, French, Italian banks -- no one wants to see this happen and they aren’t going to let it.
We hear rumors daily—for example, on Thursday some small unknown Chinese bank supposedly stopped doing business with SocGen—it was false and certainly benefitted the rumor monger as it dropped the futures 200 points alone in just 10 minutes (of course the futures recovered and we had a nice day—hope he/she lost his/her shirt)—but most of these are just plain false. Yet while many of these fears/rumors are unfounded, the volatility they create is not helping to improve trading liquidity. Furthermore, the liquidity that the Central Banks are pumping into the markets is losing its benefits as investors take it for granted. It is clear that the global economy is slowing, and risk is being re-priced. But that doesn’t mean one cannot make money in stocks. In fact, as we have all seen over the last 3 years, the pendulum can over swing both ways until sanity prevails. At the moment, we believe risk is being overpriced and will return to normal slowly but in short order.
The good news is that right now our markets are functioning: $10Bln in new corporate bonds priced last week alone as companies took advantage of negative real interest rates to clean up their balance sheets. That's an important data point. It means that investors still have cash to put to work and issuers can still come to market. It also means that Corporate America is getting healthier and while dislocations such as negative real rates can persist for a time, the bond markets and, most likely the equity markets, have overreacted and we are due for a reversal. This morning Japan reported much better than expected GDP. And we have only seen upward revisions to S&P 500 earnings projections since earnings season. No, this is not 2008 although it may feel like it. We suggest you turn off the financial news, enjoy your summer vacation and let the capital markets quiet down and sort themselves out. They always do—even post 2008.
Monday, August 8, 2011
Ramblings of a Portfolio Manager
Dear Investor:
After Last week’s market turmoil you no doubt are scared and rethinking what crazed decision ever lead you to invest in stocks in the first place. That’s only natural. You’re also probably going to be watching all the Financial TV pundits over the weekend, from Nouriel Roubini, telling us Armageddon is just around the corner to Warren Buffett, waving his little American flag singing “buy buy buy.” How can you make sense of all this rhetoric and jargon? Where were these geniuses’ 2000 Dow points higher?
We thought long and hard about what to write this week but in doing so we ran across this week’s Barron’s piece on the week gone by. Now, we all know Barron’s can be a fairly bearish publication but we found a surprising amount of bullishness in what they had to say. So rather than cobble together something on our own, we reprint here, in part, an article from that publication we thought accurately paralleled our thoughts. Full credit to Barron’s and the author for the piece, we take no credit other than finding it online at midnight last night and seeing that the article is both sober and balanced.
Barron's(8/8) Attention, Shoppers. It's Time To Buy
12:10 AM Eastern Daylight Time Aug 06, 2011
(From BARRON'S)
By Andrew Bary
After the recent plunge in major global markets, U.S. stocks look attractive. The benchmark Standard & Poor's 500 index trades for little more than 12 times projected 2011 profits, one of the lowest price/earnings ratios in a generation. The Dow Jones Industrial Average has a similar P/E -- 11.6 times this year's estimated earnings. Its dividend yield of 2.62% exceeds the depressed 2.56% yield on the 10-year Treasury note, another rare occurrence. This isn't the1970s, when P/E ratios were low but inflation and interest rates were high. Investors are worried about different problems: a weakening domestic economy, Europe's debt mess, political dysfunction in Washington and a massive and seemingly intractable federal budget deficit. Yet American corporations rarely have been in better shape, with generally robust profits and balance sheets flush with more than $1 trillion in cash. Analysts are loath to predict when the sell-off, which began July 22, might end, but many say they see stocks ending the year higher. If the S&P 500 merely gets back to its 2011 peak, set in April, the index would rise 14%. "The economy is doing well enough to keep earnings rising and bring some bullishness back to the stock market," says Jim Paulsen, investment strategist at Wells Capital Management.
Investors have been rattled by the swift pace of the sell-off, in which the S&P 500 fell more than 10% in 10 trading sessions. This marks only the fourth such decline in a bull market since the end of World War II. The other three 10% drops occurred in late 1974, October 1997 (during the Asian crisis) and August 1998 (after the collapse of the hedge fund Long-Term Capital Management). The good news is that the market rallied an average of 18% in the ensuing three months after each of those three setbacks, according to J.P. Morgan strategist Thomas Lee. Stocks might be near a bottom after a week of selling. The Dow finished Friday at 11,444.61, up 60.93 points in a volatile session but down 5.8% for the week. Most of the damage occurred Thursday, when the average fell 512 points, or 4.3%, its biggest point drop since late 2008. The industrials are down 1.2% for the year; they were up 10.7% at their April peak. The S&P 500 ended the week at 1,199.38, off 7.2% for the five days and 4.6% for the year. The situation is worse overseas, as the table nearby shows. The Euro Stoxx 50 index is down 15% this year, Japan's Nikkei is off 9% and formerly once-hot Brazilian stocks are down 24%. Every major European market except Switzerland has a P/E below 10, and European stocks yield an average of 4%. Closer to home, the top 50 U.S. banks trade on average at around book value. They have been cheaper only twice in the past 25 years-during the deep recession of 1990 and the 2009 financial crisis. Both those times were major buying opportunities, and today, notes RBC Capital Markets analyst Gerard Cassidy, the industry's fundamentals are improving. At 37.60 a share, J.P. Morgan Chase (ticker: JPM) trades below book value and for under eight times projected 2011 profits. The stock yields 2.7%, which is likely is going higher. Citigroup (C), at 33.44, is down 29% this year and trades for less than 75% of book value of $48.75. Tangible book is a conservative measure of shareholder equity that excludes goodwill and other intangible assets stemming from acquisitions. Goldman Sachs (GS), at 125.18, trades just above tangible book, and Morgan Stanley (MS), at 20.02, changes hands below tangible book of $26.97. A wobbly global economy poses risks for big financials, but the industry's capital levels are appreciably higher than in 2008 and leverage is lower. It will be tough for most big financial companies to earn 15%-plus returns on equity in the coming years-a performance that was common before 2008-given higher mandated capital levels. But the stocks are priced for single-digit returns or worse. Drug stocks, normally defensive, haven't done a lot to protect investors lately. Pfizer (PFE), at 17.49, trades for around eight times estimated 2011 profits, while Merck (MRK), at 31.71, has a similar P/E ratio. Both yield more than 4.5%.Government pressure on drug-cost reimbursements could escalate around the world, but that concern seems captured in drug stocks' low valuations. Technology companies have more exposure to Europe than other stock-market sectors, but they also have excellent balance sheets and low price/earnings multiples. Microsoft (MSFT), at 25.68, trades for nine times estimated earnings for the fiscal year ending next June. Its P/E, excluding net cash and investments of $6 a share, is under eight. Intel (INTC), at 20.79, trades for nine times projected 2011 profits and yields 4%, while Hewlett-Packard (HPQ), at 32.63 fetches less than seven times current-year profits. Apple (AAPL) the market's premier mega-cap growth stock, at 373.62, trades for 14 times what it is likely to earn in the fiscal year ending September. Excluding $80 a share in cash and investments, its P/E is closer to 10. In the energy sector, many investors prefer exploration plays and oil-service stocks, but the best value could lie in industry giants like ExxonMobil (XOM) and Chevron (CVX). At 74.82, Exxon trades for under nine times projected 2011 profits and yields 2.5%, while Chevron, at 97.61, has a P/E of just seven based on estimated 2011 net. It yields 3.2%. The recent drop in U.S. oil prices to $87 a barrel from $100 could pressure profits, but the stocks look to be discounting far lower oil and gas prices. The prospect of cuts in the Pentagon budget has crunched defense stocks. Northrop Grumman (NOC), for instance, now trades at 55.49, down from 70 in early July, and sports a P/E of eight. It yields 3.6%. Lockheed Martin (LMT), another major contractor, trades for 72.82, or 9.7 times earnings, and yields 4%. Gold has been a bright spot, rising $36 an ounce last week to $1,663.80. The metal is up 17% so far this year. Gold is shining because investors fear that the U.S. government will continue to pursue policies-notably zero-percent rates and massive fiscal deficits-that will further debase the dollar and spark inflation. Gold remains an "underowned" asset class with few individuals and institutions with a sizable weighting, which could mean more buying. While gold has gained, major producers have lagged. The leading miner, Barrick Gold (ABX), is down 14% this year to 45.86, and trades for just 10 times estimated 2011 profits. Gold bugs weren't happy that Barrick paid up to buy a major copper miner earlier this year, diluting its exposure to gold. There is rumored to have been heavy selling of Barrick by some institutional investors in recent months. Even so, Barrick has rarely had such a low P/E and its profits have a lot of leverage to gold prices. Berkshire Hathaway (BRKA) is a financial Fort Knox, with one of the strongest balance sheets among huge companies. Its shares have been no safe haven, falling11% this year to $107,300, or just 1.1 times book value. Berkshire looks inexpensive with a price/book ratio that has rarely been lower in recent decades. Its earnings power has never been better. Berkshire CEO Warren Buffett has been cool to stock buybacks -- the company has repurchased virtually no stock since he took over in 1965 -- but he ought to consider a buyback rather than paying cash for another major acquisition, given Berkshire's low valuation. Stocks had a tough summer in 2010 as the S&P 500 dropped 15% from its spring high to a low of about 1,050 in late August. That proved to be a buying opportunity as Federal Reserve Chairman Ben Bernanke came to the rescue with a new credit-easing program, known as QE2. By the end of 2010, stocks had risen 20% from their August lows. While the Fed is more reluctant to begin a fresh asset-buying plan this year, stocks look even cheaper than they were last summer. Historically, it has been good to buy the stock market when its trades around 10 times earnings. Barring global financial mayhem, investors with a modicum of patience should do well. Stocks could be the best asset class in the world.
After Last week’s market turmoil you no doubt are scared and rethinking what crazed decision ever lead you to invest in stocks in the first place. That’s only natural. You’re also probably going to be watching all the Financial TV pundits over the weekend, from Nouriel Roubini, telling us Armageddon is just around the corner to Warren Buffett, waving his little American flag singing “buy buy buy.” How can you make sense of all this rhetoric and jargon? Where were these geniuses’ 2000 Dow points higher?
We thought long and hard about what to write this week but in doing so we ran across this week’s Barron’s piece on the week gone by. Now, we all know Barron’s can be a fairly bearish publication but we found a surprising amount of bullishness in what they had to say. So rather than cobble together something on our own, we reprint here, in part, an article from that publication we thought accurately paralleled our thoughts. Full credit to Barron’s and the author for the piece, we take no credit other than finding it online at midnight last night and seeing that the article is both sober and balanced.
Barron's(8/8) Attention, Shoppers. It's Time To Buy
12:10 AM Eastern Daylight Time Aug 06, 2011
(From BARRON'S)
By Andrew Bary
After the recent plunge in major global markets, U.S. stocks look attractive. The benchmark Standard & Poor's 500 index trades for little more than 12 times projected 2011 profits, one of the lowest price/earnings ratios in a generation. The Dow Jones Industrial Average has a similar P/E -- 11.6 times this year's estimated earnings. Its dividend yield of 2.62% exceeds the depressed 2.56% yield on the 10-year Treasury note, another rare occurrence. This isn't the1970s, when P/E ratios were low but inflation and interest rates were high. Investors are worried about different problems: a weakening domestic economy, Europe's debt mess, political dysfunction in Washington and a massive and seemingly intractable federal budget deficit. Yet American corporations rarely have been in better shape, with generally robust profits and balance sheets flush with more than $1 trillion in cash. Analysts are loath to predict when the sell-off, which began July 22, might end, but many say they see stocks ending the year higher. If the S&P 500 merely gets back to its 2011 peak, set in April, the index would rise 14%. "The economy is doing well enough to keep earnings rising and bring some bullishness back to the stock market," says Jim Paulsen, investment strategist at Wells Capital Management.
Investors have been rattled by the swift pace of the sell-off, in which the S&P 500 fell more than 10% in 10 trading sessions. This marks only the fourth such decline in a bull market since the end of World War II. The other three 10% drops occurred in late 1974, October 1997 (during the Asian crisis) and August 1998 (after the collapse of the hedge fund Long-Term Capital Management). The good news is that the market rallied an average of 18% in the ensuing three months after each of those three setbacks, according to J.P. Morgan strategist Thomas Lee. Stocks might be near a bottom after a week of selling. The Dow finished Friday at 11,444.61, up 60.93 points in a volatile session but down 5.8% for the week. Most of the damage occurred Thursday, when the average fell 512 points, or 4.3%, its biggest point drop since late 2008. The industrials are down 1.2% for the year; they were up 10.7% at their April peak. The S&P 500 ended the week at 1,199.38, off 7.2% for the five days and 4.6% for the year. The situation is worse overseas, as the table nearby shows. The Euro Stoxx 50 index is down 15% this year, Japan's Nikkei is off 9% and formerly once-hot Brazilian stocks are down 24%. Every major European market except Switzerland has a P/E below 10, and European stocks yield an average of 4%. Closer to home, the top 50 U.S. banks trade on average at around book value. They have been cheaper only twice in the past 25 years-during the deep recession of 1990 and the 2009 financial crisis. Both those times were major buying opportunities, and today, notes RBC Capital Markets analyst Gerard Cassidy, the industry's fundamentals are improving. At 37.60 a share, J.P. Morgan Chase (ticker: JPM) trades below book value and for under eight times projected 2011 profits. The stock yields 2.7%, which is likely is going higher. Citigroup (C), at 33.44, is down 29% this year and trades for less than 75% of book value of $48.75. Tangible book is a conservative measure of shareholder equity that excludes goodwill and other intangible assets stemming from acquisitions. Goldman Sachs (GS), at 125.18, trades just above tangible book, and Morgan Stanley (MS), at 20.02, changes hands below tangible book of $26.97. A wobbly global economy poses risks for big financials, but the industry's capital levels are appreciably higher than in 2008 and leverage is lower. It will be tough for most big financial companies to earn 15%-plus returns on equity in the coming years-a performance that was common before 2008-given higher mandated capital levels. But the stocks are priced for single-digit returns or worse. Drug stocks, normally defensive, haven't done a lot to protect investors lately. Pfizer (PFE), at 17.49, trades for around eight times estimated 2011 profits, while Merck (MRK), at 31.71, has a similar P/E ratio. Both yield more than 4.5%.Government pressure on drug-cost reimbursements could escalate around the world, but that concern seems captured in drug stocks' low valuations. Technology companies have more exposure to Europe than other stock-market sectors, but they also have excellent balance sheets and low price/earnings multiples. Microsoft (MSFT), at 25.68, trades for nine times estimated earnings for the fiscal year ending next June. Its P/E, excluding net cash and investments of $6 a share, is under eight. Intel (INTC), at 20.79, trades for nine times projected 2011 profits and yields 4%, while Hewlett-Packard (HPQ), at 32.63 fetches less than seven times current-year profits. Apple (AAPL) the market's premier mega-cap growth stock, at 373.62, trades for 14 times what it is likely to earn in the fiscal year ending September. Excluding $80 a share in cash and investments, its P/E is closer to 10. In the energy sector, many investors prefer exploration plays and oil-service stocks, but the best value could lie in industry giants like ExxonMobil (XOM) and Chevron (CVX). At 74.82, Exxon trades for under nine times projected 2011 profits and yields 2.5%, while Chevron, at 97.61, has a P/E of just seven based on estimated 2011 net. It yields 3.2%. The recent drop in U.S. oil prices to $87 a barrel from $100 could pressure profits, but the stocks look to be discounting far lower oil and gas prices. The prospect of cuts in the Pentagon budget has crunched defense stocks. Northrop Grumman (NOC), for instance, now trades at 55.49, down from 70 in early July, and sports a P/E of eight. It yields 3.6%. Lockheed Martin (LMT), another major contractor, trades for 72.82, or 9.7 times earnings, and yields 4%. Gold has been a bright spot, rising $36 an ounce last week to $1,663.80. The metal is up 17% so far this year. Gold is shining because investors fear that the U.S. government will continue to pursue policies-notably zero-percent rates and massive fiscal deficits-that will further debase the dollar and spark inflation. Gold remains an "underowned" asset class with few individuals and institutions with a sizable weighting, which could mean more buying. While gold has gained, major producers have lagged. The leading miner, Barrick Gold (ABX), is down 14% this year to 45.86, and trades for just 10 times estimated 2011 profits. Gold bugs weren't happy that Barrick paid up to buy a major copper miner earlier this year, diluting its exposure to gold. There is rumored to have been heavy selling of Barrick by some institutional investors in recent months. Even so, Barrick has rarely had such a low P/E and its profits have a lot of leverage to gold prices. Berkshire Hathaway (BRKA) is a financial Fort Knox, with one of the strongest balance sheets among huge companies. Its shares have been no safe haven, falling11% this year to $107,300, or just 1.1 times book value. Berkshire looks inexpensive with a price/book ratio that has rarely been lower in recent decades. Its earnings power has never been better. Berkshire CEO Warren Buffett has been cool to stock buybacks -- the company has repurchased virtually no stock since he took over in 1965 -- but he ought to consider a buyback rather than paying cash for another major acquisition, given Berkshire's low valuation. Stocks had a tough summer in 2010 as the S&P 500 dropped 15% from its spring high to a low of about 1,050 in late August. That proved to be a buying opportunity as Federal Reserve Chairman Ben Bernanke came to the rescue with a new credit-easing program, known as QE2. By the end of 2010, stocks had risen 20% from their August lows. While the Fed is more reluctant to begin a fresh asset-buying plan this year, stocks look even cheaper than they were last summer. Historically, it has been good to buy the stock market when its trades around 10 times earnings. Barring global financial mayhem, investors with a modicum of patience should do well. Stocks could be the best asset class in the world.
Tuesday, July 19, 2011
Ramblings of a Portfolio Manager
Will We Get a Budget Deal and What Will Be Left of the Economy When We Do?
We don’t have to bring everyone up to speed on the current status of the budget/debt ceiling negotiations going on in Washington. Suffice to say that each side remains intractable on their respective positions with Obama shuttling back and forth proposing noble but clearly unpassable “deals” in order to save face for the elections next year. Meanwhile, our Treasury Secretary and Federal Reserve Chairman alike continue to warn the parties not to play a game of Chicken with our debt rating and, ultimately our economy, backed up by rating agencies who, though discredited over the past few years, still carry weight when it comes to existing contracts and indentures and, ultimately, the interest rate paid by the entities they rate.
While all of this makes for a good side show and the current yield on the long bonds suggests that the markets expect a deal to be done to avoid default before the August 2nd deadline, missing from the popular headlines is what the negotiations themselves may be doing to the economy, in a sense making any “deal” moot by the time it becomes passed. Few noticed that several small rating agencies have actually become proactive and have already dropped our debt rating one notch. Moody’s and S&P, however, are the 800 lb. gorillas to whom everyone pays attention and whose ratings are written into bond indentures across corporate America. Still, what those smaller firms say and said are telling. Being proactive, they looked at whatever a potential deal might be and what the ongoing negations have been doing to corporate behavior in the months leading up to that deal. What they arrived at makes total sense and is a good basis for their downgrades. Corporate heads watch CNBC too and the growing sense that the “deal” will come to the wire and be much less than is what is really needed to get this Country on the right track for the next decade, let alone to the next election, is, once again, causing great uncertainty. In fact, this Administration’s legacy will be the uncertainty they have caused with business given all their regulations, policy shifts and new spending programs. That uncertainty has hampered hiring since Obama took office and, just as it looked as though, perhaps, Companies were about to try to forge ahead no matter, around comes another bout of uncertainty—the outcome of the budget talks.
What CEO, who’s debt is tied to LIBOR, Prime or, gasp, Treasuries, is going to make capital spending and hiring plans not knowing what rates he/she will be paying on that debt in 3 weeks? To do anything, frankly, would be irresponsible. Everyone was shocked at the poor employment numbers released in early July but they made total sense—Corporate America is frozen in its expansion plans pending the outcome of the “great deal.” And this time, we cant just blame the Obama administration—the Republicans are as much at fault for the deadlock and the uncertainty it is causing. Now everyone is looking toward the August release. We can almost guarantee they will be as bad if not worse than those released in July, as company’s sat on the sidelines in wait and see mode. Meanwhile, many municipalities , who’s debt payments are tied to the rate on US Treasuries, are making contingency plans should the negotiations go past August 2nd or should the promised downgrades occur. Geithner and Bernanke were’t kidding when they said the outcome of a default will be disasterous. Our 9.2% unemployment rate will balloon as Federal, State and Municipal employees are let go in droves after a default. Bottom line, those little rating agencies looked ahead and saw the damage the current gridlock is already doing to the economy and, knowing a weakened economy cannot pay its debts as well as a strong one, did the right thing and did their downgrades.
So what to do? Frankly, we do expect a deal and a very small one at that, one that cuts spending over a lengthy period of time. Will such a deal be good enough for the rating agencies? We hope so. If that deal is accepted by Moody’s and S&P and we retain our rating, then we expect a nice market rally. Why? Because such a deal is yet more can kicking and preserves current spending and tax levels, items deemed important in helping the US get back on its feet. As for rates, well they may even rise on hopes of a future recovery. Still, we wonder what might be if the dolts who we elected actually get together and come up with some meaningful cuts. The markets are willing to assign higher multiples to unleveraged companies and the same holds true for the economy as a whole. A $4-$6trillion cut might provide the leverage reduction the markets seek and produce an even bigger rally. We doubt we’ll ever see such a deal but for now a deal, any deal, that raises the debt ceiling and staves off the rating agencies, will be good for the equity markets. We hope the markets are clever enough to see the poor employment numbers we will see in August are a direct result of the uncertainty factor. If they can get past that fact, we may rally right to year end. Just expect many more Mylanta days, as we have been seeing, before that occurs.
We don’t have to bring everyone up to speed on the current status of the budget/debt ceiling negotiations going on in Washington. Suffice to say that each side remains intractable on their respective positions with Obama shuttling back and forth proposing noble but clearly unpassable “deals” in order to save face for the elections next year. Meanwhile, our Treasury Secretary and Federal Reserve Chairman alike continue to warn the parties not to play a game of Chicken with our debt rating and, ultimately our economy, backed up by rating agencies who, though discredited over the past few years, still carry weight when it comes to existing contracts and indentures and, ultimately, the interest rate paid by the entities they rate.
While all of this makes for a good side show and the current yield on the long bonds suggests that the markets expect a deal to be done to avoid default before the August 2nd deadline, missing from the popular headlines is what the negotiations themselves may be doing to the economy, in a sense making any “deal” moot by the time it becomes passed. Few noticed that several small rating agencies have actually become proactive and have already dropped our debt rating one notch. Moody’s and S&P, however, are the 800 lb. gorillas to whom everyone pays attention and whose ratings are written into bond indentures across corporate America. Still, what those smaller firms say and said are telling. Being proactive, they looked at whatever a potential deal might be and what the ongoing negations have been doing to corporate behavior in the months leading up to that deal. What they arrived at makes total sense and is a good basis for their downgrades. Corporate heads watch CNBC too and the growing sense that the “deal” will come to the wire and be much less than is what is really needed to get this Country on the right track for the next decade, let alone to the next election, is, once again, causing great uncertainty. In fact, this Administration’s legacy will be the uncertainty they have caused with business given all their regulations, policy shifts and new spending programs. That uncertainty has hampered hiring since Obama took office and, just as it looked as though, perhaps, Companies were about to try to forge ahead no matter, around comes another bout of uncertainty—the outcome of the budget talks.
What CEO, who’s debt is tied to LIBOR, Prime or, gasp, Treasuries, is going to make capital spending and hiring plans not knowing what rates he/she will be paying on that debt in 3 weeks? To do anything, frankly, would be irresponsible. Everyone was shocked at the poor employment numbers released in early July but they made total sense—Corporate America is frozen in its expansion plans pending the outcome of the “great deal.” And this time, we cant just blame the Obama administration—the Republicans are as much at fault for the deadlock and the uncertainty it is causing. Now everyone is looking toward the August release. We can almost guarantee they will be as bad if not worse than those released in July, as company’s sat on the sidelines in wait and see mode. Meanwhile, many municipalities , who’s debt payments are tied to the rate on US Treasuries, are making contingency plans should the negotiations go past August 2nd or should the promised downgrades occur. Geithner and Bernanke were’t kidding when they said the outcome of a default will be disasterous. Our 9.2% unemployment rate will balloon as Federal, State and Municipal employees are let go in droves after a default. Bottom line, those little rating agencies looked ahead and saw the damage the current gridlock is already doing to the economy and, knowing a weakened economy cannot pay its debts as well as a strong one, did the right thing and did their downgrades.
So what to do? Frankly, we do expect a deal and a very small one at that, one that cuts spending over a lengthy period of time. Will such a deal be good enough for the rating agencies? We hope so. If that deal is accepted by Moody’s and S&P and we retain our rating, then we expect a nice market rally. Why? Because such a deal is yet more can kicking and preserves current spending and tax levels, items deemed important in helping the US get back on its feet. As for rates, well they may even rise on hopes of a future recovery. Still, we wonder what might be if the dolts who we elected actually get together and come up with some meaningful cuts. The markets are willing to assign higher multiples to unleveraged companies and the same holds true for the economy as a whole. A $4-$6trillion cut might provide the leverage reduction the markets seek and produce an even bigger rally. We doubt we’ll ever see such a deal but for now a deal, any deal, that raises the debt ceiling and staves off the rating agencies, will be good for the equity markets. We hope the markets are clever enough to see the poor employment numbers we will see in August are a direct result of the uncertainty factor. If they can get past that fact, we may rally right to year end. Just expect many more Mylanta days, as we have been seeing, before that occurs.
Monday, July 11, 2011
Ramblings of a Portfolio Manager
Here We Go Again?
We awoke early this morning to find futures for markets around the world, including our own, sharply lower, while many Asian markets had already closed deeply in the red. The cause: a trifecta of yet another Southern European debt-laden country nearing a crisis—in this case Italy, the apparent breakdown in debt reduction talks between Obama and the US Congress over the weekend, and, most likely, some carry over from the poor jobs report in the US on Friday. US bond yields, which were heading higher after the strong PMI numbers we received here last week, are back below 3% for the 10-year Treasuries. In short, just about everything that made the markets rally off their bottom in late June—the resolution of the crisis in Greek debt, optimism over a debt deal in the US and a promising ADP jobs report, seem to have been undone since last Friday morning. This, of course, begs the question, are we going right back to our June lows this time quicker than the sickening 6 week slide that got us there? We don’t think so.
Let’s look rationally at each piece of news, one at a time. First, as for Italy, this is no Greece. Yes, it is a much larger market but it is also much different in its behavior toward austerity. We note that the Italians have already put in place some severe austerity programs voluntarily and have already taken steps to reduce their sovereign debt. The IMF has already agreed to backstop Italy and there will be no anxiety-riddled days of waiting on a vote from the Italian Government on a vote to accept the aid and the conditions that go with it. In addition, the situation in Italy is not new news but that doesn’t seem to matter these days. Any weakness on the “Italian Affair” will most likely be a buying opportunity.
As for the spending and debt reduction talks here at home, it did indeed look like Obama had struck a promising $4trillion deal with Congress last week and the markets liked that. Over the weekend, however, old biases crept back in from each side with the republicans backing away over tax hikes for the “wealthy” and our good friend Nancy Pelosi backtracking on any kind of cuts in entitlements. Both of these items were part of each side’s give and take that would have made a $4trillion deal work. Obama has yet to give up on his ambition plan, as it would have been somewhat of an election-enhancing coupe for him, however it looks more likely that a plan with cuts have the size will be what we get. In any case, both sides have made noise about contingency plans on raising the debt ceiling so that should not be a concern, even if they do bring it down to the wire. Furthermore, sad as it may be, a $2trillion deal would actually be better for the US economy as it would include smaller tax and spending cuts. Yes, it does kick the can further down the road but it would be a good start and one that hopefully keeps rates at home and the value of the dollar low, both of which will only continue to benefit the US economy.
Finally, we can’t discount the lousy jobs report we got Friday morning. There was little in that report that was encouraging for employment prospects in the US. We do note, however, that the Monster Employment Index, released the same day, was +3.5%, its best showing since early 2008, prior to the financial crises. Unlike the Government’s data, which is backward looking, this index is real-time data from employers regarding their intent to take on more employees. The ADP report, which is being ridiculed of late do to its apparent “inaccuracy”, is also real-time from a broad swath of employers. In many ways, it is more up to date and accurate than the government’s data. Remember, if the economists are correct about the idea of a temporary slowdown thanks to Japan and oil, that fact would have been captured in the June data, which it apparently was. In sum, we believe the July employment data will be much better, but we will have to wait for that to see. One thing is for sure, with such weak data, there is now more pressure on the Fed to implement a QE3 style program. Look for a softening tone from some of the Fed governors and certainly no talk of liquidity withdrawal for the conceivable future.
So, should we be concerned or is this a buying opportunity. Ultimately, we believe all three issues will be resolved or seen for what they are—temporary—but despite the recent rally the markets are nervous so we may see some weakness over the next few days. The key will be what companies say during their conference calls. So far, the few that have reported have “beat and raised” meaning they see the current slowdown as temporary. Bellwether Alcoa reports tonight and that may well set the tone for what we hear going forward. With its costs falling and prices for its products rising, we think that report will be good and, perhaps, just what this nervous market needs to hear.
We awoke early this morning to find futures for markets around the world, including our own, sharply lower, while many Asian markets had already closed deeply in the red. The cause: a trifecta of yet another Southern European debt-laden country nearing a crisis—in this case Italy, the apparent breakdown in debt reduction talks between Obama and the US Congress over the weekend, and, most likely, some carry over from the poor jobs report in the US on Friday. US bond yields, which were heading higher after the strong PMI numbers we received here last week, are back below 3% for the 10-year Treasuries. In short, just about everything that made the markets rally off their bottom in late June—the resolution of the crisis in Greek debt, optimism over a debt deal in the US and a promising ADP jobs report, seem to have been undone since last Friday morning. This, of course, begs the question, are we going right back to our June lows this time quicker than the sickening 6 week slide that got us there? We don’t think so.
Let’s look rationally at each piece of news, one at a time. First, as for Italy, this is no Greece. Yes, it is a much larger market but it is also much different in its behavior toward austerity. We note that the Italians have already put in place some severe austerity programs voluntarily and have already taken steps to reduce their sovereign debt. The IMF has already agreed to backstop Italy and there will be no anxiety-riddled days of waiting on a vote from the Italian Government on a vote to accept the aid and the conditions that go with it. In addition, the situation in Italy is not new news but that doesn’t seem to matter these days. Any weakness on the “Italian Affair” will most likely be a buying opportunity.
As for the spending and debt reduction talks here at home, it did indeed look like Obama had struck a promising $4trillion deal with Congress last week and the markets liked that. Over the weekend, however, old biases crept back in from each side with the republicans backing away over tax hikes for the “wealthy” and our good friend Nancy Pelosi backtracking on any kind of cuts in entitlements. Both of these items were part of each side’s give and take that would have made a $4trillion deal work. Obama has yet to give up on his ambition plan, as it would have been somewhat of an election-enhancing coupe for him, however it looks more likely that a plan with cuts have the size will be what we get. In any case, both sides have made noise about contingency plans on raising the debt ceiling so that should not be a concern, even if they do bring it down to the wire. Furthermore, sad as it may be, a $2trillion deal would actually be better for the US economy as it would include smaller tax and spending cuts. Yes, it does kick the can further down the road but it would be a good start and one that hopefully keeps rates at home and the value of the dollar low, both of which will only continue to benefit the US economy.
Finally, we can’t discount the lousy jobs report we got Friday morning. There was little in that report that was encouraging for employment prospects in the US. We do note, however, that the Monster Employment Index, released the same day, was +3.5%, its best showing since early 2008, prior to the financial crises. Unlike the Government’s data, which is backward looking, this index is real-time data from employers regarding their intent to take on more employees. The ADP report, which is being ridiculed of late do to its apparent “inaccuracy”, is also real-time from a broad swath of employers. In many ways, it is more up to date and accurate than the government’s data. Remember, if the economists are correct about the idea of a temporary slowdown thanks to Japan and oil, that fact would have been captured in the June data, which it apparently was. In sum, we believe the July employment data will be much better, but we will have to wait for that to see. One thing is for sure, with such weak data, there is now more pressure on the Fed to implement a QE3 style program. Look for a softening tone from some of the Fed governors and certainly no talk of liquidity withdrawal for the conceivable future.
So, should we be concerned or is this a buying opportunity. Ultimately, we believe all three issues will be resolved or seen for what they are—temporary—but despite the recent rally the markets are nervous so we may see some weakness over the next few days. The key will be what companies say during their conference calls. So far, the few that have reported have “beat and raised” meaning they see the current slowdown as temporary. Bellwether Alcoa reports tonight and that may well set the tone for what we hear going forward. With its costs falling and prices for its products rising, we think that report will be good and, perhaps, just what this nervous market needs to hear.
Monday, June 27, 2011
Ramblings of a Portfolio Manager
Is QE2 Really Dead?
With Greece back in the headlines—and we’ve said quite enough on that subject--we thought we’d take the opportunity to talk a little about one of the other of the myriad concerns the US equity markets have been focused upon over the last two months—the coming end to QE2. Very few government actions have been so well telegraphed to the markets yet the equity, currency and bond markets have been roiling over the last two months as they fight to determine what, if anything, will be the exact effect of the end of the Federal Reserve’s program to support bond prices and keep interest rates and the dollar low with the purchase of US Treasuries.
QE2’s goal was to support asset prices through the purchase of $600 billion of US Government debt issues. The hope was that higher asset (equity, bond) prices would lead to the wealth effect among consumers and businesses alike, spurring spending and, eventually, production and hiring. Whether the program was a success or not remains to be seen. Of late we have received some fairly weak economic data from the US, including employment, which has called into doubt the efficacy of the program. Our thesis is that the effects of QE2 have a lag and that the full impact of higher asset prices and easy money has yet to kick in and be seen in US economic data. In the meantime, economic data, as it always is coming out of a recession, has been lumpy causing many to declare the program a failure. We choose to wait and see. In the meantime, while economists fret over the pending end to QE2 and the apparent lack of a successor, they ignore one very important artifact of the program from the outset—the Fed, now the largest owner of US Treasuries, is earning some decent interest rates on its purchases. In fact, the Fed’s balance sheet now stands at close to $2.9 trillion. With Fed Chairman Ben Bernanke declaring that it will be some time before the Federal Reserve begins to unload its considerable holdings in Treasuries, some pretty sizable interest payments will be hitting the Fed’s income statement. What will they do with all that money?
On June 22 the Fed concluded its monthly Open Market Committee meeting and Bernanke gave a rare press interview shortly thereafter. The takeaway for the markets, as we saw in equity price actions that day and the next, was that there would be no QE3, something many traders and economists alike were hoping for to continue to support asset prices. What was largely ignored, however, is that the Fed said on June 22 that it will continue to buy Treasuries with proceeds from the maturing debt it currently owns. Given the size of its balance sheet, that could mean purchases (reinvestment) of as much as $300 billion of government debt over the next 12 months without adding any additional money to the financial system. That means that the central bank will continue buying Treasuries to keep market rates down as the economy slows. And those purchases will continue to support demand at bond auctions while Obama and Republicans in Congress struggle to close the gap between federal spending and income by between $2 trillion and $4 trillion. So not only is the Fed maintaining its accommodative stance, it is, in effect, launching into an unofficial QE2.5—something the markets have yet to focus upon.
Of the Fed’s bond holdings, a total of $112.1 billion will mature in the next 12 months, 7 percent of the $1.59 trillion in Treasuries held in its system open market account. Just replacing those securities will require the Fed to buy an average of $9.4 billion of Treasuries a month through June 2012. The Fed also holds $914.4 billion of mortgage-backed debt and $118.4 billion of debentures, the debt of government sponsored enterprises Fannie Mae and Freddie Mac. Estimates are that $10 billion to $16 billion will mature each month, depending on the pace of prepayments. That is yet more liquidity that will be reinvested into the system if the Fed decides to keep its balance sheet size the same, as it has openly declared.
Helping the Fed with its low interest rate policy has been the flight to quality by investors in the face of European debt concerns. Treasury 10-year yields fell to the lowest since Dec. 1 last week, down from this year’s high of 3.77 percent on Feb. 9. On June 24, the two-year yield came within one basis point of the record low, set November 2010, reaching 0.32 percent. And so far there’s been no lack of demand for government securities even as US Treasury debt has grown to $9.26 trillion from $4.5 trillion at the start of the financial crisis in August 2007, and $5.75 trillion when Obama took office in January 2009.
Most economists don’t expect that the Fed will raise its zero to 0.25 percent interest target rate for overnight loans between banks until the first quarter of next year. At his June 22 conference, Bernanke declared that the inflationary pressures we saw earlier this year are abating, in his opinion, and yields on 10-year Treasury Inflation Protected Securities show bond traders project an average 2.2 percentage point inflation, up only modestly from the 1.5 percentage points the way back in August 2010, when Bernanke first indicated the central bank might resume debt purchases to fight deflation. That suggests the first interest rate hike may be well into next year—beyond Q1
Bottom line: the asset purchases the Fed must make, even if they occur on a smaller scale, over the next year still continues the strategy that the Fed was trying to accomplish in the first place. That means that even with the end of QE2, the liquidity flow and its fundamental impact will remain intact for some time to come. So even though the market is going through a correction in anticipation of QE2’s demise, we may very well see the resumption of the liquidity driven rally.
With Greece back in the headlines—and we’ve said quite enough on that subject--we thought we’d take the opportunity to talk a little about one of the other of the myriad concerns the US equity markets have been focused upon over the last two months—the coming end to QE2. Very few government actions have been so well telegraphed to the markets yet the equity, currency and bond markets have been roiling over the last two months as they fight to determine what, if anything, will be the exact effect of the end of the Federal Reserve’s program to support bond prices and keep interest rates and the dollar low with the purchase of US Treasuries.
QE2’s goal was to support asset prices through the purchase of $600 billion of US Government debt issues. The hope was that higher asset (equity, bond) prices would lead to the wealth effect among consumers and businesses alike, spurring spending and, eventually, production and hiring. Whether the program was a success or not remains to be seen. Of late we have received some fairly weak economic data from the US, including employment, which has called into doubt the efficacy of the program. Our thesis is that the effects of QE2 have a lag and that the full impact of higher asset prices and easy money has yet to kick in and be seen in US economic data. In the meantime, economic data, as it always is coming out of a recession, has been lumpy causing many to declare the program a failure. We choose to wait and see. In the meantime, while economists fret over the pending end to QE2 and the apparent lack of a successor, they ignore one very important artifact of the program from the outset—the Fed, now the largest owner of US Treasuries, is earning some decent interest rates on its purchases. In fact, the Fed’s balance sheet now stands at close to $2.9 trillion. With Fed Chairman Ben Bernanke declaring that it will be some time before the Federal Reserve begins to unload its considerable holdings in Treasuries, some pretty sizable interest payments will be hitting the Fed’s income statement. What will they do with all that money?
On June 22 the Fed concluded its monthly Open Market Committee meeting and Bernanke gave a rare press interview shortly thereafter. The takeaway for the markets, as we saw in equity price actions that day and the next, was that there would be no QE3, something many traders and economists alike were hoping for to continue to support asset prices. What was largely ignored, however, is that the Fed said on June 22 that it will continue to buy Treasuries with proceeds from the maturing debt it currently owns. Given the size of its balance sheet, that could mean purchases (reinvestment) of as much as $300 billion of government debt over the next 12 months without adding any additional money to the financial system. That means that the central bank will continue buying Treasuries to keep market rates down as the economy slows. And those purchases will continue to support demand at bond auctions while Obama and Republicans in Congress struggle to close the gap between federal spending and income by between $2 trillion and $4 trillion. So not only is the Fed maintaining its accommodative stance, it is, in effect, launching into an unofficial QE2.5—something the markets have yet to focus upon.
Of the Fed’s bond holdings, a total of $112.1 billion will mature in the next 12 months, 7 percent of the $1.59 trillion in Treasuries held in its system open market account. Just replacing those securities will require the Fed to buy an average of $9.4 billion of Treasuries a month through June 2012. The Fed also holds $914.4 billion of mortgage-backed debt and $118.4 billion of debentures, the debt of government sponsored enterprises Fannie Mae and Freddie Mac. Estimates are that $10 billion to $16 billion will mature each month, depending on the pace of prepayments. That is yet more liquidity that will be reinvested into the system if the Fed decides to keep its balance sheet size the same, as it has openly declared.
Helping the Fed with its low interest rate policy has been the flight to quality by investors in the face of European debt concerns. Treasury 10-year yields fell to the lowest since Dec. 1 last week, down from this year’s high of 3.77 percent on Feb. 9. On June 24, the two-year yield came within one basis point of the record low, set November 2010, reaching 0.32 percent. And so far there’s been no lack of demand for government securities even as US Treasury debt has grown to $9.26 trillion from $4.5 trillion at the start of the financial crisis in August 2007, and $5.75 trillion when Obama took office in January 2009.
Most economists don’t expect that the Fed will raise its zero to 0.25 percent interest target rate for overnight loans between banks until the first quarter of next year. At his June 22 conference, Bernanke declared that the inflationary pressures we saw earlier this year are abating, in his opinion, and yields on 10-year Treasury Inflation Protected Securities show bond traders project an average 2.2 percentage point inflation, up only modestly from the 1.5 percentage points the way back in August 2010, when Bernanke first indicated the central bank might resume debt purchases to fight deflation. That suggests the first interest rate hike may be well into next year—beyond Q1
Bottom line: the asset purchases the Fed must make, even if they occur on a smaller scale, over the next year still continues the strategy that the Fed was trying to accomplish in the first place. That means that even with the end of QE2, the liquidity flow and its fundamental impact will remain intact for some time to come. So even though the market is going through a correction in anticipation of QE2’s demise, we may very well see the resumption of the liquidity driven rally.
Monday, June 20, 2011
Ramblings of a Portfolio Manager
If Everyone is so Bearish, Who is Left to Sell?
The Dow managed to avoid 7 straight weeks of declines on Friday but just by the skin of its teeth. Rising 30bps, about the amount it needed to stay in the positive for the week, most of the “rally” came on hopes of a weekend bailout package for Greece—something similar to a European version of the Lehman weekend we all experienced back in October of 2008. Unfortunately, investors didn’t get their wish and the futures look ugly this morning.
Most readers know we aren’t big proponents of technical analysis and even less convinced Greece is meaningful but in a time where investors throw out fundamentals based on macro fears, we do concede that technicals have a role, if only for the reason that people do look at them. So we decided to take our own look at some of the more popular indicators to get an updated idea of sentiment and where it might be pointing in terms of where the markets might be heading over the next few months, regardless of what the fundamentals may be.
Ok, this is a lot of data and its’ not clear to the casual observer what to make of it. We have two takeaways. First, the trend is consistently down—i.e. negative. So anyone who tells you there is too much bullishness in this market is probably full of it himself. Secondly, the most reliable indicator we have back tested, the CBOE Equity Put/Call ratio, is getting close to its high from October of 2008 (extremely bearish), when the world was thought to be falling apart, and coincidentally, right now sits just atop of where it was on March 2009, the market’s bottom.
Reading this data, our sense is that we are getting close to a bottom on investor sentiment. Since 2008 we have had over 10 5% pullbacks, a record and one which is based on still fresh memories of 2008. Now, bottoming sentiment doesn’t necessarily mean that stocks will rebound but it’s a good clue that they probably will stop going down. Then, given the huge short interest ratio, if we are correct in our assumption that economic data will come in higher than expected in the third and fourth quarter and pairing it with the bottoms up fundamental data we keep hearing from our companies (beating estimates, raising forecasts) and valuations, we may have a recipe for a decent rally in stocks by year end.
We hope everyone had a great Father’s Day
The Dow managed to avoid 7 straight weeks of declines on Friday but just by the skin of its teeth. Rising 30bps, about the amount it needed to stay in the positive for the week, most of the “rally” came on hopes of a weekend bailout package for Greece—something similar to a European version of the Lehman weekend we all experienced back in October of 2008. Unfortunately, investors didn’t get their wish and the futures look ugly this morning.
Most readers know we aren’t big proponents of technical analysis and even less convinced Greece is meaningful but in a time where investors throw out fundamentals based on macro fears, we do concede that technicals have a role, if only for the reason that people do look at them. So we decided to take our own look at some of the more popular indicators to get an updated idea of sentiment and where it might be pointing in terms of where the markets might be heading over the next few months, regardless of what the fundamentals may be.
Ok, this is a lot of data and its’ not clear to the casual observer what to make of it. We have two takeaways. First, the trend is consistently down—i.e. negative. So anyone who tells you there is too much bullishness in this market is probably full of it himself. Secondly, the most reliable indicator we have back tested, the CBOE Equity Put/Call ratio, is getting close to its high from October of 2008 (extremely bearish), when the world was thought to be falling apart, and coincidentally, right now sits just atop of where it was on March 2009, the market’s bottom.
Reading this data, our sense is that we are getting close to a bottom on investor sentiment. Since 2008 we have had over 10 5% pullbacks, a record and one which is based on still fresh memories of 2008. Now, bottoming sentiment doesn’t necessarily mean that stocks will rebound but it’s a good clue that they probably will stop going down. Then, given the huge short interest ratio, if we are correct in our assumption that economic data will come in higher than expected in the third and fourth quarter and pairing it with the bottoms up fundamental data we keep hearing from our companies (beating estimates, raising forecasts) and valuations, we may have a recipe for a decent rally in stocks by year end.
We hope everyone had a great Father’s Day
Monday, June 6, 2011
Ramblings of a Portfolio Manager
Double Dip Talk Again?
How fickle the equity markets can be. One to two data points and the markets can change their tone on a dime. Case in point—not so long ago as mid-April many economists were talking hyper inflation, large interest rate hikes and a soaring dollar. Several weak data points later, including Friday’s miserable jobs report, and Treasury yields are back at nearly an all time low, the Euro is closing back in on $1.49 and those same pundits are now exploring a double dip recessionary scenario. The equity markets, of course, have followed in sync. With little political will for a QE3 so far, one must ask did we hit a soft patch or is the economy in Q1 or is the economy just in the process of transforming itself from stimulus-based growth to a self-sustaining engine? Just a reminder: economies NEVER move in a straight line.
A few encouraging points were missed last week. The Non-Manufacturing ISM, released on Friday as well, is still in expansion mode. Over the last 12 months the ISM non-manufacturing index has averaged 55.4 and May came in at 54.6 suggesting that this sector of the economy is still on track for an expansion. Continued gains here suggest continued gains in core retail sales and therefore consumer spending and the economy. That would mean no double-dip although it hardly suggests an accelerating economy. A few takeaways from the Non-Manufacturing ISM: Overall business activity rose in 14 industries, including real estate (interesting), construction, finance & insurance, healthcare and information. That these gains are so broad is reassuring as is the overall size of the gains. Orders were up in May with gains in 15 Industries and new orders came in at 56.8 in May compared to 52.7 in April. Among the 15 industries signaling growth were professional services, transportation, finance & insurance, healthcare and information. Since the current recover began, these sectors have exhibited job gains and an expansion in their sales. The current outlook of the US. Economy is for continued growth in these service sectors as the share of total consumer spending on services continues to grow over time. Another take away is that export orders grew in sectors such as art, entertainment & recreation, professional services, accommodation and
food services—all sectors where a strong, historical orientation to consumer service provides American suppliers with a comparative advantage.
Another oft talked about but seemingly ignored fact is prices paid, a measure of costs to the consumer. The ISM showed that prices paid increased in May again, but the index dropped to 69.6 from 70.1 in April. Seventeen industries reported an increase in prices paid, including real estate (a positive sign), accommodation & food (certainly no surprise), healthcare and professional services. Now, this may be a double-edged sword as rising prices paid suggest that many firms are getting squeezed at the bottom line in the short term and many retailers proved that it is likely that companies are having difficulty passing on input costs to their final customers given the problems faced by many consumers. However, though many commodities are up in price for non-manufacturing companies including airfares, copper, cotton, diesel fuel, gasoline and many oil derivative products these prices are expected to come down, particularly if our Chinese and Indian trading partners are successful in engineering soft landings in their respective economies (some economists are coming around to the view that these two countries are nearing the end of their tightening.. The market’s obvious fear, in the short term, is that these rising prices will crimp margins and thus earnings. However, we just came through earnings seasons for most industrial companies affected by rising input costs (retailers are still reporting) and few, if any industries, complained about their inability to pass on higher prices. True, retailers had difficulties but with a record cotton crop going into the ground the spring, that issue may also be alleviated in the fall. Gasoline is falling, which also benefits the consumer.
Of course, the Non Manufacturing ISM is but one data point but are not the markets reacting to every headline these days. Also overlooked is the fact that Greece finally, actually, really may have a resolution to their issues. That would put further downward pressure on the dollar, benefiting our exporters. Now, no country every devalued its way to prosperity, however, in the short-term, a continued weak dollar should help our exporters, bolster commodity prices and support the US markets. None of this suggests a double dip is on the horizon. And, while hope is never a good investment philosophy, there is little doubt that the Obama administration is running scared with the upcoming Presidential elections (anyone see him blame China and Europe for our woes last week? Incredible). So don’t discount some last ditch effort to create jobs (an effort that would have to begin soon to produce the desired effect by election time) as well as pressure for the Fed to keep all that liquidity in the markets for much longer than expected. So while QE3 remains off the table, liquidity will remain high and the recent sell-off on its demise seems quite overdone.
How fickle the equity markets can be. One to two data points and the markets can change their tone on a dime. Case in point—not so long ago as mid-April many economists were talking hyper inflation, large interest rate hikes and a soaring dollar. Several weak data points later, including Friday’s miserable jobs report, and Treasury yields are back at nearly an all time low, the Euro is closing back in on $1.49 and those same pundits are now exploring a double dip recessionary scenario. The equity markets, of course, have followed in sync. With little political will for a QE3 so far, one must ask did we hit a soft patch or is the economy in Q1 or is the economy just in the process of transforming itself from stimulus-based growth to a self-sustaining engine? Just a reminder: economies NEVER move in a straight line.
A few encouraging points were missed last week. The Non-Manufacturing ISM, released on Friday as well, is still in expansion mode. Over the last 12 months the ISM non-manufacturing index has averaged 55.4 and May came in at 54.6 suggesting that this sector of the economy is still on track for an expansion. Continued gains here suggest continued gains in core retail sales and therefore consumer spending and the economy. That would mean no double-dip although it hardly suggests an accelerating economy. A few takeaways from the Non-Manufacturing ISM: Overall business activity rose in 14 industries, including real estate (interesting), construction, finance & insurance, healthcare and information. That these gains are so broad is reassuring as is the overall size of the gains. Orders were up in May with gains in 15 Industries and new orders came in at 56.8 in May compared to 52.7 in April. Among the 15 industries signaling growth were professional services, transportation, finance & insurance, healthcare and information. Since the current recover began, these sectors have exhibited job gains and an expansion in their sales. The current outlook of the US. Economy is for continued growth in these service sectors as the share of total consumer spending on services continues to grow over time. Another take away is that export orders grew in sectors such as art, entertainment & recreation, professional services, accommodation and
food services—all sectors where a strong, historical orientation to consumer service provides American suppliers with a comparative advantage.
Another oft talked about but seemingly ignored fact is prices paid, a measure of costs to the consumer. The ISM showed that prices paid increased in May again, but the index dropped to 69.6 from 70.1 in April. Seventeen industries reported an increase in prices paid, including real estate (a positive sign), accommodation & food (certainly no surprise), healthcare and professional services. Now, this may be a double-edged sword as rising prices paid suggest that many firms are getting squeezed at the bottom line in the short term and many retailers proved that it is likely that companies are having difficulty passing on input costs to their final customers given the problems faced by many consumers. However, though many commodities are up in price for non-manufacturing companies including airfares, copper, cotton, diesel fuel, gasoline and many oil derivative products these prices are expected to come down, particularly if our Chinese and Indian trading partners are successful in engineering soft landings in their respective economies (some economists are coming around to the view that these two countries are nearing the end of their tightening.. The market’s obvious fear, in the short term, is that these rising prices will crimp margins and thus earnings. However, we just came through earnings seasons for most industrial companies affected by rising input costs (retailers are still reporting) and few, if any industries, complained about their inability to pass on higher prices. True, retailers had difficulties but with a record cotton crop going into the ground the spring, that issue may also be alleviated in the fall. Gasoline is falling, which also benefits the consumer.
Of course, the Non Manufacturing ISM is but one data point but are not the markets reacting to every headline these days. Also overlooked is the fact that Greece finally, actually, really may have a resolution to their issues. That would put further downward pressure on the dollar, benefiting our exporters. Now, no country every devalued its way to prosperity, however, in the short-term, a continued weak dollar should help our exporters, bolster commodity prices and support the US markets. None of this suggests a double dip is on the horizon. And, while hope is never a good investment philosophy, there is little doubt that the Obama administration is running scared with the upcoming Presidential elections (anyone see him blame China and Europe for our woes last week? Incredible). So don’t discount some last ditch effort to create jobs (an effort that would have to begin soon to produce the desired effect by election time) as well as pressure for the Fed to keep all that liquidity in the markets for much longer than expected. So while QE3 remains off the table, liquidity will remain high and the recent sell-off on its demise seems quite overdone.
Saturday, May 28, 2011
Ramblings of a Portfolio Manager
Markets and Economy Got You Confused? Join the Crowd.
It was random and coincidental that we chose to take a hiatus from Ramblings the last two weeks—two weeks, which turned out to be some of most confusing and volatile in the US equity markets in the last few years. Frankly, we had gotten tired of constantly addressing the Euro-debt crisis (what more can one say?--Greece is still tiny last we looked and China and the IMF are still poised to help the rest of the Eurozone with a bailout), the fact that the end of QE2 has been fully discounted by the US equity markets (or so we believed), that China would not sink the global economy with its monetary tightness and may soon take its foot off the economic brakes and, finally, that US corporate earnings were due to come in strong, making this equity market cheap-really cheap when one considers the low debt and strong earnings growth sported by Corporate America amidst record low interest rates. Shame on us. Just like the markets mysteriously operate to make just about all investors and economists look as stupid as possible so too did they act similarly with those of us who write about them. Vacation over.
So what has happened since we last published Ramblings? Well, just about the opposite of what we and it seems most US market participants believed would occur. On May 1st the markets opened to the news that Osama Bin Laden had finally been expunged from this world. The news that, perhaps, the World had become a less risky place was initially greeted with a strong market surge—strength which lasted all of about one hour. Instead of the usual strong start of the month, as investors plow more idle cash into the strong equity markets, we got a quick surge followed by a fairly strong sell-off. The markets have been down every week since. What’s going on? Well, if one is to believe the pundits, investors, seeing the end of QE2 and its liquidity stream (which must have just come up as a total surprise), began to rotate out of cyclical and commodity stocks and into defensive, “growth stocks,” which presumably would outperform in a post-QE2 world. Of course the fact that rising rates, higher commodity prices and hyper-inflation had been widely predicted, all of which would have further crimped the earnings of these companies was irrelevant (did any one read the earnings reports from the likes of P&G, Kellogg, Proctor & Gamble? Not so hot given their rising input costs and inability to pass on price hikes). The consensus was that this “unexpected” end of QE2 was going to slow the economy (remember now, no-one ever believed that QE2 was going to help the economy in the first place) and that was enough to spur a flight to safety. The really perverse outcome of this line of thinking is that US Treasuries actually surged to new one year highs. Was not the end of QE2 supposed to produce a rise in rates and a corresponding fall in bonds? Many portfolio managers were poised for just such an event. Nope, the new prevailing market view was QE2’s eventual demise was going to slow the economy (again, not that anyone thought it was going to speed up the economy)--not good for stocks--and that outcome (along with this new-fangled thing called a Euro debt crisis and some real tangible evidence that China’s policies were achieving the desired soft landing—again totally unexpected) sent everyone running to the safety of US bonds. It didn’t help that Bill Gross, who has appeared on TV multiple times to tell all the world that he was short the US Treasury, was “exposed”after being proven wrong on the direction of the yield curve, and confessed that he was really only “underweighted” in those securities, not short. Even the smart, rich and powerful can be disingenuous.
Adding fuel to the fire of the last two weeks has been a slew of weak economic data coming out of the US. It started with first quarter GDP, which came in at 1.8%, roughly half of what the prior annual growth rate had been but was expected. Many reasons were cited for the slowdown but the deceleration in real GDP in the first quarter primarily reflected a sharp upturn in imports, a deceleration in PCE, a larger decrease in federal government spending, and a deceleration in nonresidential fixed investment. This was followed up by continued weak housing data, less than expected industrial production and employment numbers that, while better than prior months, failed to impress. Suddenly, it seems, investors got the idea that the end of QE2, still a month out, was already producing a slowdown in the economy and that it was time to sell stocks and/or get defensive. The term “double dip” even began to be thrown around again. Investor sentiment dropped along with cyclicals, money flowed out of equity funds and back into Treasuries, resulting in their dramatic rise and, worst of all, the dollar surged (at least temporarily) as concerned investors around the world sought the safety of our richly priced government debt—something that didn’t help commodities and may produce a self-fulfilling prophecy down the road should it persist. The data bears this out. Investor sentiment, thanks to AAII, dropped to a recent low in May:
Bullish 25.6%, down 1.1
Neutral 33.0%, up 0.9
Bearish 41.4%, up 0.1
Change from prior week:
Bullish: -1.1
Neutral: +0.9
Bearish: +0.1
Long-Term Average:
Bullish: 39%
Neutral: 31%
Bearish: 30%
Even the outflow from municipal bonds slowed and turned positive as investors either tired of selling or re-acquainted themselves with the “safety” and tax efficiency of these securities. The result: falling stocks, a rising dollar and soaring US Treasuries. The current yield on a 1-year Treasury security is now down to 18 basis points—that’s right, put your money into the “safety” of a debt instrument on the verge of a credit downgrade and, essentially, you’ll supposedly get just the same amount back in 12 months. Obviously, investors do not feel the same about equities.
So, from our perspective, that’s what happened in the first two-thirds of the month. The last week, however, operated somewhat differently. Even though the US equity markets were down on the week, a subtle shift in sentiment could be felt. Bad economic data (GDP, Philly Fed, Existing Home Sales) didn’t produce a sell-off in the equity markets nor a rally in bonds. In fact, somewhat of the opposite proved true in the last few trading days. What happened? Did investors come to their senses? Did they read something in the data the rest of us did not? Or did they decide to become long-term investors once again? We think all of the above. First, we remind everyone that the 1.8% first quarter GDP growth is only now being felt in the weekly economic data due to the lag effect. So it’s no surprise that the recent data stream has been less than robust following that report. Secondly, we believe, investors have begun to realize that the effects of QE2 (which is less than a year old) are lagging and probably wont even show up until Q3 or Q4 of this year. This latter attitude is producing what is not being called the “See over trade,” which is a term describing how investors are now beginning to look beyond the current economic weakness to either await the eventual impact of QE2 or, possibly, the introduction of some sort of QE3 or QE2.5 based on the recent data. Also included in the “see over” trade have been a number of pronouncements from Fed officials (remember all the way back to April 27th when Bernanke said the same thing) that liquidity was not going to be withdrawn quickly or, for that matter, any time soon and in the meantime the Fed is going to reinvest the proceeds of its bond sales back into the markets, essentially a reverse-sterilization process that would mitigate any impact of the end of QE2.
In the last week many major investment houses have reduced their GDP estimates for the US for the rest of the year. This has set investors on edge, however if one parses the data, one can read that the reduction in GDP is less than the prior full-year estimate less the reduction in Q1---so, essentially, the rest of the year is supposed to rise from prior forecasts. Add to that is a bump up in estimates for US GDP for 2012. The coming election year has been cited (no-one has ever been re-elected with 9% unemployment) for that rise but also there is a growing feeling (actually enunciated by our socialist Euro-counterparts) that the global economy has become self-sustaining and no longer needs external stimulus. If this theory is correct, then the recovery not only becomes self sustaining but will accelerate as strong growth leads to further strong growth and, gasp, hiring (excluding any dumb tightening moves by the Fed). We believe we are at that point now. The economy is transitioning from one of stimulus-driven growth to one which is self-sustaining. And, like any inflection point, this period is giving us mixed economic signals. In the next 6 months, however, these signals should all begin to align and point in the same direction—up—especially if the folks on Capitol Hill pull some last minute rabbits out of the hat to stay in office, something we strongly believe will happen.
So don’t get discouraged, hang on to those stocks and have a very, happy Memorial Day.
It was random and coincidental that we chose to take a hiatus from Ramblings the last two weeks—two weeks, which turned out to be some of most confusing and volatile in the US equity markets in the last few years. Frankly, we had gotten tired of constantly addressing the Euro-debt crisis (what more can one say?--Greece is still tiny last we looked and China and the IMF are still poised to help the rest of the Eurozone with a bailout), the fact that the end of QE2 has been fully discounted by the US equity markets (or so we believed), that China would not sink the global economy with its monetary tightness and may soon take its foot off the economic brakes and, finally, that US corporate earnings were due to come in strong, making this equity market cheap-really cheap when one considers the low debt and strong earnings growth sported by Corporate America amidst record low interest rates. Shame on us. Just like the markets mysteriously operate to make just about all investors and economists look as stupid as possible so too did they act similarly with those of us who write about them. Vacation over.
So what has happened since we last published Ramblings? Well, just about the opposite of what we and it seems most US market participants believed would occur. On May 1st the markets opened to the news that Osama Bin Laden had finally been expunged from this world. The news that, perhaps, the World had become a less risky place was initially greeted with a strong market surge—strength which lasted all of about one hour. Instead of the usual strong start of the month, as investors plow more idle cash into the strong equity markets, we got a quick surge followed by a fairly strong sell-off. The markets have been down every week since. What’s going on? Well, if one is to believe the pundits, investors, seeing the end of QE2 and its liquidity stream (which must have just come up as a total surprise), began to rotate out of cyclical and commodity stocks and into defensive, “growth stocks,” which presumably would outperform in a post-QE2 world. Of course the fact that rising rates, higher commodity prices and hyper-inflation had been widely predicted, all of which would have further crimped the earnings of these companies was irrelevant (did any one read the earnings reports from the likes of P&G, Kellogg, Proctor & Gamble? Not so hot given their rising input costs and inability to pass on price hikes). The consensus was that this “unexpected” end of QE2 was going to slow the economy (remember now, no-one ever believed that QE2 was going to help the economy in the first place) and that was enough to spur a flight to safety. The really perverse outcome of this line of thinking is that US Treasuries actually surged to new one year highs. Was not the end of QE2 supposed to produce a rise in rates and a corresponding fall in bonds? Many portfolio managers were poised for just such an event. Nope, the new prevailing market view was QE2’s eventual demise was going to slow the economy (again, not that anyone thought it was going to speed up the economy)--not good for stocks--and that outcome (along with this new-fangled thing called a Euro debt crisis and some real tangible evidence that China’s policies were achieving the desired soft landing—again totally unexpected) sent everyone running to the safety of US bonds. It didn’t help that Bill Gross, who has appeared on TV multiple times to tell all the world that he was short the US Treasury, was “exposed”after being proven wrong on the direction of the yield curve, and confessed that he was really only “underweighted” in those securities, not short. Even the smart, rich and powerful can be disingenuous.
Adding fuel to the fire of the last two weeks has been a slew of weak economic data coming out of the US. It started with first quarter GDP, which came in at 1.8%, roughly half of what the prior annual growth rate had been but was expected. Many reasons were cited for the slowdown but the deceleration in real GDP in the first quarter primarily reflected a sharp upturn in imports, a deceleration in PCE, a larger decrease in federal government spending, and a deceleration in nonresidential fixed investment. This was followed up by continued weak housing data, less than expected industrial production and employment numbers that, while better than prior months, failed to impress. Suddenly, it seems, investors got the idea that the end of QE2, still a month out, was already producing a slowdown in the economy and that it was time to sell stocks and/or get defensive. The term “double dip” even began to be thrown around again. Investor sentiment dropped along with cyclicals, money flowed out of equity funds and back into Treasuries, resulting in their dramatic rise and, worst of all, the dollar surged (at least temporarily) as concerned investors around the world sought the safety of our richly priced government debt—something that didn’t help commodities and may produce a self-fulfilling prophecy down the road should it persist. The data bears this out. Investor sentiment, thanks to AAII, dropped to a recent low in May:
Bullish 25.6%, down 1.1
Neutral 33.0%, up 0.9
Bearish 41.4%, up 0.1
Change from prior week:
Bullish: -1.1
Neutral: +0.9
Bearish: +0.1
Long-Term Average:
Bullish: 39%
Neutral: 31%
Bearish: 30%
Even the outflow from municipal bonds slowed and turned positive as investors either tired of selling or re-acquainted themselves with the “safety” and tax efficiency of these securities. The result: falling stocks, a rising dollar and soaring US Treasuries. The current yield on a 1-year Treasury security is now down to 18 basis points—that’s right, put your money into the “safety” of a debt instrument on the verge of a credit downgrade and, essentially, you’ll supposedly get just the same amount back in 12 months. Obviously, investors do not feel the same about equities.
So, from our perspective, that’s what happened in the first two-thirds of the month. The last week, however, operated somewhat differently. Even though the US equity markets were down on the week, a subtle shift in sentiment could be felt. Bad economic data (GDP, Philly Fed, Existing Home Sales) didn’t produce a sell-off in the equity markets nor a rally in bonds. In fact, somewhat of the opposite proved true in the last few trading days. What happened? Did investors come to their senses? Did they read something in the data the rest of us did not? Or did they decide to become long-term investors once again? We think all of the above. First, we remind everyone that the 1.8% first quarter GDP growth is only now being felt in the weekly economic data due to the lag effect. So it’s no surprise that the recent data stream has been less than robust following that report. Secondly, we believe, investors have begun to realize that the effects of QE2 (which is less than a year old) are lagging and probably wont even show up until Q3 or Q4 of this year. This latter attitude is producing what is not being called the “See over trade,” which is a term describing how investors are now beginning to look beyond the current economic weakness to either await the eventual impact of QE2 or, possibly, the introduction of some sort of QE3 or QE2.5 based on the recent data. Also included in the “see over” trade have been a number of pronouncements from Fed officials (remember all the way back to April 27th when Bernanke said the same thing) that liquidity was not going to be withdrawn quickly or, for that matter, any time soon and in the meantime the Fed is going to reinvest the proceeds of its bond sales back into the markets, essentially a reverse-sterilization process that would mitigate any impact of the end of QE2.
In the last week many major investment houses have reduced their GDP estimates for the US for the rest of the year. This has set investors on edge, however if one parses the data, one can read that the reduction in GDP is less than the prior full-year estimate less the reduction in Q1---so, essentially, the rest of the year is supposed to rise from prior forecasts. Add to that is a bump up in estimates for US GDP for 2012. The coming election year has been cited (no-one has ever been re-elected with 9% unemployment) for that rise but also there is a growing feeling (actually enunciated by our socialist Euro-counterparts) that the global economy has become self-sustaining and no longer needs external stimulus. If this theory is correct, then the recovery not only becomes self sustaining but will accelerate as strong growth leads to further strong growth and, gasp, hiring (excluding any dumb tightening moves by the Fed). We believe we are at that point now. The economy is transitioning from one of stimulus-driven growth to one which is self-sustaining. And, like any inflection point, this period is giving us mixed economic signals. In the next 6 months, however, these signals should all begin to align and point in the same direction—up—especially if the folks on Capitol Hill pull some last minute rabbits out of the hat to stay in office, something we strongly believe will happen.
So don’t get discouraged, hang on to those stocks and have a very, happy Memorial Day.
Monday, May 9, 2011
Ramblings of a Portfolio Manager
Sit on it or Rotate?
What the heck happened last week? “ What?” You Say? From most investors’ perspective it was a relative calm week. Though May didn’t start off with a big rise, as we have seen in prior months, a look at the indices shows that all, on the surface, was fairly calm. The Dow pulled back a modest 1.3% but the S&P 500 fell a more severe 2.1% and the Russell 2000 dropped 3.7%. Profit taking? “Sell in May and Go Away?” Some “de risking” ahead of the halt of the Fed liquidity stream? Europe again? Yes.
Actually, the raw index data belies the real underlying damage that was done to many sectors and their constituent stocks. Of the 10 S&P sectors, only one rose during the week, and that was Healthcare, up a modest 0.03%. Selected sectors, particularly ones that have done well this year, were taken to the woodshed with Energy down 7.3%, Materials down 4.5% and Industrials down 2.5%. Financials and Technology also took it on the chin, down 2% respectively. And these are the S&P sectors, composed of large cap stocks. The movements at the small-cap end of the spectrum were even more severe—almost double across the board. Is this the long awaited “major” pullback that strategists have been espousing for months now or something more subtle yet, in its own right, more severe? We think the latter.
The week/month actually started on a high note. Over the weekend we received news that our arch enemy, Osama Bin Laden, had been killed in Pakistan and much valuable Intel had been gleaned from his computers and records. That news alone sent the morning futures into triple digits. However, by the end of Monday, all major indices were in the red with the Russell 2000 taking the biggest hit, down over 1% on the day. The Dow, which held strong for most of the day, succumbed at the end and posted a modest loss. So was this “sell in May.” Well, there was selling for sure but there was also some buying—it depended upon what sector one looks at. With Energy, Materials and Industrials taking the brunt of the hit, one could point a finger squarely at the dollar. After all, the key to these sectors all year has been a weaker dollar. In fact, the dollar did rise for most of the week and the equity markets responded with their expected inverse relationship. The temptation would be to simply dismiss the action as investors’ attempt to get ahead of the Fed’s inevitable withdrawal of liquidity from the system slated, in Ben Bernanke’s words, for several months from now. We remind investors that a simple halt to QE2 does not mean an instant withdrawal of liquidity—we, like Japan, can sit for months, years, with low rates and lots of liquidity in the system. And in some ways, the actions of certain asset classes last week bore this theory out—bonds actually rose during the week, something most portfolio managers would expect to happen in reverse once the Fed stopped buying. So what was going on last week? Did simple patriotism cause a flight to the dollar and US bonds?
From our perspective last week was a sector rotation, plain and simple, but a strong one at that. Consumer growth companies and health care, the old fall backs in a weakening economy, far outperformed the cyclical sectors of energy and materials. The fact that we got some weak data during the week (weak GDP, ADP, Service Sector PMI) only reinforces this viewpoint. Fears of Fed tightening had little to do with this—in fact, the Fed factored in little except that Bernanke made it clear we would not have a QE3 and that, combined with weak economic data, scared many investors into thoughts that that the economy couldn’t stand on its own—i.e. that we would be headed toward a double dip once QE2 came to an end. That thinking explained much. Flight to the safe haven of Treasuries and the Dollar seem to be the rule when things look weak here (confirming that the Dollar remains the world’s reserve currency) and the rotation into less cyclical sectors confirmed the trend. By the end of the week, we saw somewhat of a reversal of trend but rumors of Greece pulling out of the EU stoked more headline risk and the rebound rally lost most of its steam.
So are we headed for a double dip or, at the least, a weakening economy? As we write Goldman Sachs is cutting its GDP forecast for the rest of the year by 0.50%. Not the stuff of a double dip but not heading in the right direction either. The worrisome part is that our foreign trading partners are still struggling to reign in their own economies, something that, if they are successful, will dampen foreign demand for our exports. Again, not something good for robust GDP at home. While we still believe that QE3 is not yet on the table, the Obama administration is up for reelection in 2010 and 9% unemployment just isn’t going to get him reelected. Then again, throwing us back into recession with squabbling over debt ceilings and Social Security cuts isn’t going to retain that republican majority either. So there is impetus on Capitol Hill to get things moving. In the end, we think the Fed will once again come to the rescue and hold off on any liquidity withdrawal until at least next year. And if the data continues to come through weak, then we may see loose monetary policy deep into 2012 or later. Maybe even QE3. Are we in Japan, you ask? It’s beginning to look like it.
What the heck happened last week? “ What?” You Say? From most investors’ perspective it was a relative calm week. Though May didn’t start off with a big rise, as we have seen in prior months, a look at the indices shows that all, on the surface, was fairly calm. The Dow pulled back a modest 1.3% but the S&P 500 fell a more severe 2.1% and the Russell 2000 dropped 3.7%. Profit taking? “Sell in May and Go Away?” Some “de risking” ahead of the halt of the Fed liquidity stream? Europe again? Yes.
Actually, the raw index data belies the real underlying damage that was done to many sectors and their constituent stocks. Of the 10 S&P sectors, only one rose during the week, and that was Healthcare, up a modest 0.03%. Selected sectors, particularly ones that have done well this year, were taken to the woodshed with Energy down 7.3%, Materials down 4.5% and Industrials down 2.5%. Financials and Technology also took it on the chin, down 2% respectively. And these are the S&P sectors, composed of large cap stocks. The movements at the small-cap end of the spectrum were even more severe—almost double across the board. Is this the long awaited “major” pullback that strategists have been espousing for months now or something more subtle yet, in its own right, more severe? We think the latter.
The week/month actually started on a high note. Over the weekend we received news that our arch enemy, Osama Bin Laden, had been killed in Pakistan and much valuable Intel had been gleaned from his computers and records. That news alone sent the morning futures into triple digits. However, by the end of Monday, all major indices were in the red with the Russell 2000 taking the biggest hit, down over 1% on the day. The Dow, which held strong for most of the day, succumbed at the end and posted a modest loss. So was this “sell in May.” Well, there was selling for sure but there was also some buying—it depended upon what sector one looks at. With Energy, Materials and Industrials taking the brunt of the hit, one could point a finger squarely at the dollar. After all, the key to these sectors all year has been a weaker dollar. In fact, the dollar did rise for most of the week and the equity markets responded with their expected inverse relationship. The temptation would be to simply dismiss the action as investors’ attempt to get ahead of the Fed’s inevitable withdrawal of liquidity from the system slated, in Ben Bernanke’s words, for several months from now. We remind investors that a simple halt to QE2 does not mean an instant withdrawal of liquidity—we, like Japan, can sit for months, years, with low rates and lots of liquidity in the system. And in some ways, the actions of certain asset classes last week bore this theory out—bonds actually rose during the week, something most portfolio managers would expect to happen in reverse once the Fed stopped buying. So what was going on last week? Did simple patriotism cause a flight to the dollar and US bonds?
From our perspective last week was a sector rotation, plain and simple, but a strong one at that. Consumer growth companies and health care, the old fall backs in a weakening economy, far outperformed the cyclical sectors of energy and materials. The fact that we got some weak data during the week (weak GDP, ADP, Service Sector PMI) only reinforces this viewpoint. Fears of Fed tightening had little to do with this—in fact, the Fed factored in little except that Bernanke made it clear we would not have a QE3 and that, combined with weak economic data, scared many investors into thoughts that that the economy couldn’t stand on its own—i.e. that we would be headed toward a double dip once QE2 came to an end. That thinking explained much. Flight to the safe haven of Treasuries and the Dollar seem to be the rule when things look weak here (confirming that the Dollar remains the world’s reserve currency) and the rotation into less cyclical sectors confirmed the trend. By the end of the week, we saw somewhat of a reversal of trend but rumors of Greece pulling out of the EU stoked more headline risk and the rebound rally lost most of its steam.
So are we headed for a double dip or, at the least, a weakening economy? As we write Goldman Sachs is cutting its GDP forecast for the rest of the year by 0.50%. Not the stuff of a double dip but not heading in the right direction either. The worrisome part is that our foreign trading partners are still struggling to reign in their own economies, something that, if they are successful, will dampen foreign demand for our exports. Again, not something good for robust GDP at home. While we still believe that QE3 is not yet on the table, the Obama administration is up for reelection in 2010 and 9% unemployment just isn’t going to get him reelected. Then again, throwing us back into recession with squabbling over debt ceilings and Social Security cuts isn’t going to retain that republican majority either. So there is impetus on Capitol Hill to get things moving. In the end, we think the Fed will once again come to the rescue and hold off on any liquidity withdrawal until at least next year. And if the data continues to come through weak, then we may see loose monetary policy deep into 2012 or later. Maybe even QE3. Are we in Japan, you ask? It’s beginning to look like it.
Monday, April 25, 2011
Ramblings of a Portfolio Manager
Standard & Poors Just Issued a Warning on US Government Debt. What a Great Time to Buy US Government Debt!
Last Monday was a harrowing and confusing day in the US capital markets—a day that demonstrated the perverse, sometimes conflicting, nature of investing in financial assets: assets whose prices are determined not by any particular standardized underlying valuation metric but by the supply and demand dynamics of a wide range of investors, from the Ivory Tower PhD quants down to the trailer park chat-room day traders.
US investors awoke Monday to find the US equity market futures already deep in the red. Once again Europe’s debt woes (particularly Greece) had been thrust into the front of the headlines, with more rhetoric about default and further restructurings amid a tanking economy thanks to austerity measures. Like many, we assumed the day would play out as it had for the entire year—weaker hands would be shaken out of US stocks and into Treasuries in the morning, only for the reverse to happen later in the day when the “smart money” took advantage of what was essentially old news to do some bargain hunting. After all, “every” smart investor know that QE2 will be ending soon, producing an outflow from Treasuries, presumably into the next best alternative, US equities. It wasn’t to be. Late in the morning, before the US markets opened, the futures tanked even more and the news hit the wires that Standard & Poors, that Gold Standard, leading edge credit rating agency, which had given AAA rating status to most of the Credit Default Swaps and esoteric real-estate derivative products that almost sunk the world’s financial markets in 2008, had just put the entire outstanding balance of United States Treasuries (and future issuances) on a “negative” from “stable” outlook. For S&P, it was the first step in a 3 step process toward a full downgrade of US debt from its exalted AAA status, a distinction it has held for nearly 80 years, and signaled that years of profligate spending and mounting debt with nothing but political rhetoric and no solutions to the issue, had finally caught up with the world’s largest economy. The outcrop—if the US did not address its deficit and ballooning debt problem, S&P would most likely downgrade the country’s debt from its AAA status within 2 years.
Of course, the rational investor, trained in Friedman, Keynes, Malkiel and Samuelson, to name a few, expected that the bond market would tank that day and though money might not flow directly from Treasuries to stocks, at least the expectation was that the reaction in the equity markets would be “tame.” In fact, the rational investor, including us, was once again taken aback by the perverse nature of the capital markets of late. Financial instruments have never moved exactly as predicted by the text books and that relationship has broken down over time but seldom do we see a complete 180 turn from what would logically be expected. Last Monday, we saw that with the Dow trading down as much as 240 points on heavy volume, while the longer Treasury maturities, after a brief dip, beginning to climb. Huh? If the US were to lose its AAA status, would not it have to pay higher interest rates and, given the relationship between rates and bond prices, would not bonds sink? One would think so but, as we mentioned, the opposite happened, although stocks did recover some of their initial losses over the course of the day.
What happened? The brain trust of economists are still scratching their heads and fiddling with their models replete with Greek symbols, crunching them on Cray’s latest supercomputer. Meanwhile, the rest of us have cobbled together a more homespun explanation for what happened. First of all, some sort of action by the rating agencies was most likely expected by the bond market (heck if we know what the equity markets were expecting-remember influence of the trailer park day traders) and the one we got was the mildest of the moves S&P could make; in fact, it wasn’t even the step before a downgrade: we still have to go on “credit watch negative” before a downgrade is imminent. Secondly, S&P gave us a 33% chance of a downgrade in 2 years. That’s better than even money and extends beyond the next election when we hope (as we always do) that a more fiscally responsible group of politicians will take office. Thirdly and relatedly, the move was seen as indeed political, with S&P basing its decision more on the gridlock it sees in the current Congress than any deeper economic weakness of structural problem in the economy. Fourth, Moody’s ever the politician itself, quickly reassured the markets (and big brother) that it had no intention of following suit with a negative rating of its own. Finally, many in the markets saw the move as a call to action to the politicians—the proverbial straw that would break the camel’s back of gridlock and rhetoric and get those sound bite hogs in DC focused on the real matter at hand—cutting the deficit and reducing our outstanding debt load. It is interesting to note that the dollar fell on that day, as would initially be expected, but stayed low even as bonds rallied. Anyone think the Fed stepped in under QE2 to mitigate the fallout?
That’s a long-winded explanation of why bonds probably didn’t sell off, but why did the equity markets tank and why did bonds actually end up on the day? The answer here is probably more subtle and complex. Compared to what we said about bond market participants above, equity market players are less thoughtful, more reactive and just don’t do as much homework. To them, the reverse was true—S&P’s warning shot might cause Congress to overreact, following the UK and implementing austerity measures before the economy has fully recovered—maybe even canceling the QE3 through 15 that some expected. In addition, failing a resolution, a full downgrade of the US (2 years out at the least) would affect US corporations as well, raising the cost of their borrowings, which are now at an all time low. That would also serve to put the brakes on the fledgling recovery. Finally, the move was seen as changing Bernanke’s Wednesday Q&A on QE2, from something benign to something more hawkish. All of this would be bad for the economy and bad, ultimately, for corporate earnings and thus stocks. So why did US Treasuries rise on the day? Well, as we all know, when the US (or global) economy is seen as potentially having negative issues, investors “de risk” (someone please explain that term to us and how it is done in an hour on trillions of dollars) and flee to quality; the only perceived quality investment left (barring Switzerland and gold) is, you guessed it, US Treasuries. Gold was up on the day, as was Silver. This phenomenon has been seen many times in other countries—during a debt downgrade, it is equities that take the brunt of the downgrade. The funny thing is, following the news, a spate of strong US corporate earnings came out, pushing the yields (and prices) higher, signaling a stronger economy ahead and negating much of the flight to quality (but Gold and Silver still rose, this time on inflation fears—go figure).
Oh, and our 2 cents (less than 0.01 Swiss Franc now) is that Bernanke now comes out even more dovish than expected on April 27th. What simpler and politically more palatable way to avoid a debt crisis than to continue to deflate our currency, paying back our debt faster with worthless dollars, thus simultaneously stimulating our economy further and collecting more taxes at the same nominal rate and avoiding economic or political repercussions of a tax hike or austerity. Anyone see supply side economics in here anywhere? We think this would successfully avoid a downgrade (a growing economy, shrinking debt and higher taxes would keep the ratings fools at bay despite the devalued currency). QE3, we think, just got more probable so we would avoid the Dollar. We’re still not sure what to do about Treasuries, although we certainly wouldn’t hold them here. We just hope the Chinese don’t start voting with their feet (or Bloombergs to be precise). Welcome to the Bizarro Land of investing.
Last Monday was a harrowing and confusing day in the US capital markets—a day that demonstrated the perverse, sometimes conflicting, nature of investing in financial assets: assets whose prices are determined not by any particular standardized underlying valuation metric but by the supply and demand dynamics of a wide range of investors, from the Ivory Tower PhD quants down to the trailer park chat-room day traders.
US investors awoke Monday to find the US equity market futures already deep in the red. Once again Europe’s debt woes (particularly Greece) had been thrust into the front of the headlines, with more rhetoric about default and further restructurings amid a tanking economy thanks to austerity measures. Like many, we assumed the day would play out as it had for the entire year—weaker hands would be shaken out of US stocks and into Treasuries in the morning, only for the reverse to happen later in the day when the “smart money” took advantage of what was essentially old news to do some bargain hunting. After all, “every” smart investor know that QE2 will be ending soon, producing an outflow from Treasuries, presumably into the next best alternative, US equities. It wasn’t to be. Late in the morning, before the US markets opened, the futures tanked even more and the news hit the wires that Standard & Poors, that Gold Standard, leading edge credit rating agency, which had given AAA rating status to most of the Credit Default Swaps and esoteric real-estate derivative products that almost sunk the world’s financial markets in 2008, had just put the entire outstanding balance of United States Treasuries (and future issuances) on a “negative” from “stable” outlook. For S&P, it was the first step in a 3 step process toward a full downgrade of US debt from its exalted AAA status, a distinction it has held for nearly 80 years, and signaled that years of profligate spending and mounting debt with nothing but political rhetoric and no solutions to the issue, had finally caught up with the world’s largest economy. The outcrop—if the US did not address its deficit and ballooning debt problem, S&P would most likely downgrade the country’s debt from its AAA status within 2 years.
Of course, the rational investor, trained in Friedman, Keynes, Malkiel and Samuelson, to name a few, expected that the bond market would tank that day and though money might not flow directly from Treasuries to stocks, at least the expectation was that the reaction in the equity markets would be “tame.” In fact, the rational investor, including us, was once again taken aback by the perverse nature of the capital markets of late. Financial instruments have never moved exactly as predicted by the text books and that relationship has broken down over time but seldom do we see a complete 180 turn from what would logically be expected. Last Monday, we saw that with the Dow trading down as much as 240 points on heavy volume, while the longer Treasury maturities, after a brief dip, beginning to climb. Huh? If the US were to lose its AAA status, would not it have to pay higher interest rates and, given the relationship between rates and bond prices, would not bonds sink? One would think so but, as we mentioned, the opposite happened, although stocks did recover some of their initial losses over the course of the day.
What happened? The brain trust of economists are still scratching their heads and fiddling with their models replete with Greek symbols, crunching them on Cray’s latest supercomputer. Meanwhile, the rest of us have cobbled together a more homespun explanation for what happened. First of all, some sort of action by the rating agencies was most likely expected by the bond market (heck if we know what the equity markets were expecting-remember influence of the trailer park day traders) and the one we got was the mildest of the moves S&P could make; in fact, it wasn’t even the step before a downgrade: we still have to go on “credit watch negative” before a downgrade is imminent. Secondly, S&P gave us a 33% chance of a downgrade in 2 years. That’s better than even money and extends beyond the next election when we hope (as we always do) that a more fiscally responsible group of politicians will take office. Thirdly and relatedly, the move was seen as indeed political, with S&P basing its decision more on the gridlock it sees in the current Congress than any deeper economic weakness of structural problem in the economy. Fourth, Moody’s ever the politician itself, quickly reassured the markets (and big brother) that it had no intention of following suit with a negative rating of its own. Finally, many in the markets saw the move as a call to action to the politicians—the proverbial straw that would break the camel’s back of gridlock and rhetoric and get those sound bite hogs in DC focused on the real matter at hand—cutting the deficit and reducing our outstanding debt load. It is interesting to note that the dollar fell on that day, as would initially be expected, but stayed low even as bonds rallied. Anyone think the Fed stepped in under QE2 to mitigate the fallout?
That’s a long-winded explanation of why bonds probably didn’t sell off, but why did the equity markets tank and why did bonds actually end up on the day? The answer here is probably more subtle and complex. Compared to what we said about bond market participants above, equity market players are less thoughtful, more reactive and just don’t do as much homework. To them, the reverse was true—S&P’s warning shot might cause Congress to overreact, following the UK and implementing austerity measures before the economy has fully recovered—maybe even canceling the QE3 through 15 that some expected. In addition, failing a resolution, a full downgrade of the US (2 years out at the least) would affect US corporations as well, raising the cost of their borrowings, which are now at an all time low. That would also serve to put the brakes on the fledgling recovery. Finally, the move was seen as changing Bernanke’s Wednesday Q&A on QE2, from something benign to something more hawkish. All of this would be bad for the economy and bad, ultimately, for corporate earnings and thus stocks. So why did US Treasuries rise on the day? Well, as we all know, when the US (or global) economy is seen as potentially having negative issues, investors “de risk” (someone please explain that term to us and how it is done in an hour on trillions of dollars) and flee to quality; the only perceived quality investment left (barring Switzerland and gold) is, you guessed it, US Treasuries. Gold was up on the day, as was Silver. This phenomenon has been seen many times in other countries—during a debt downgrade, it is equities that take the brunt of the downgrade. The funny thing is, following the news, a spate of strong US corporate earnings came out, pushing the yields (and prices) higher, signaling a stronger economy ahead and negating much of the flight to quality (but Gold and Silver still rose, this time on inflation fears—go figure).
Oh, and our 2 cents (less than 0.01 Swiss Franc now) is that Bernanke now comes out even more dovish than expected on April 27th. What simpler and politically more palatable way to avoid a debt crisis than to continue to deflate our currency, paying back our debt faster with worthless dollars, thus simultaneously stimulating our economy further and collecting more taxes at the same nominal rate and avoiding economic or political repercussions of a tax hike or austerity. Anyone see supply side economics in here anywhere? We think this would successfully avoid a downgrade (a growing economy, shrinking debt and higher taxes would keep the ratings fools at bay despite the devalued currency). QE3, we think, just got more probable so we would avoid the Dollar. We’re still not sure what to do about Treasuries, although we certainly wouldn’t hold them here. We just hope the Chinese don’t start voting with their feet (or Bloombergs to be precise). Welcome to the Bizarro Land of investing.
Monday, April 18, 2011
Ramblings of a Portfolio Manager
Which Asylum is Being Run by the Inmates?
Over the weekend the Chinese Central Bank ordered the State’s banks to set aside more cash reserves in an effort to curb lending and escalating inflation. This is the 4th such reserve increase this year alone and China’s largest banks will now have to hold 20.5% of their capital in cash reserves. The move comes on the back of the Bank’s April 6th benchmark interest rate hike, the 4th since the beginning of 2010, and was in response to Friday’s report that the Chinese economy had grown 9.7% year over year, higher than the projected 9.5%. Since the PBOC began its efforts to slow the Chinese economy in 2010, through a series of rate and reserve hikes, the economy has shown little to no signs of easing its rapid growth. The one sector of the economy that has shown some response is the Chinese property market, which was ostensibly the PBOC’s initial primary target. Since the tightening cycle began, the Chinese property market has cooled from its torrid pace of 2009-2010 yet it is still growing. The latest report shows residential property values up 6% so far in 2011, less than the 7% annual growth of 2010, and that number is expected to decline further into 2012.
One would expect, with such restrictive monetary policy, the Chinese equity markets, along with their Asian counterparts, would be heading south daily in anticipation of much weaker economic news ahead. Instead, the Shanghai Composite was up 22bps overnight and most other Asian markets were essentially flat. European markets, however, are down over 1% and US equity futures are pointing to a much lower opening. In fact, this is a pattern that has been repeated since late January and since that time the Shanghai Composite is up nearly 14%, besting both Europe and the US, all while China has been applying the brakes. Now, to the astute US equity investor, this might seem perverse. Surely, from past experience, we know that rising interest rates in the US are almost always associated with a decline in the stock market so why is the same not happening in China? In fact, a larger question is why are rate hikes in China having more of an effect on European and US markets than on its own?
There are several answers to this conundrum (we use this word purposefully). First, looking back at history, even in the US an initial round of rate hikes does little to bring down the equity markets. There are many explanations for this phenomenon but the reason is probably a combination of several factors: first, most rate hikes in the US are well telegraphed so the first few hikes are never a surprise; second is investors’ initial belief that that rate hikes will be modest and short in duration (remember “one and done?”); third is the inevitable initial cash flow out of fixed income securities and into equities, which serves to prop up the stock market in the short term; finally is the belief among many investors that the Federal Reserve is often late and can do little to effectively apply the brakes once the economy has begun to run—the old “Genie out of the bottle” analogy. Much of these same reasons may well apply to the current Chinese market. Surely, the PBOC’s tightening has come as no surprise and even though there is no Chinese Treasury money to flow into stocks, the currency has appreciated less than rates, keeping the export economy relatively strong and that, of course, feeds into the belief that the rate hikes will be ineffective in slowing economic growth. And even if the tightening is effective, what will be the new growth rate-- 8%? Still not bad given the valuations of Chinese equities. Chinese investors, as well, may not recall the PBOC’s last tightening cycle, which went overboard, throwing the economy into a recession, and so continue to doubt the efficacy of the Bank’s policies.
The ultimate question, of course, is why are the monetary policies of China having more of an affect of US markets (at least in the short run) than they are on Asian equities? We see this every time the Chinese Central Bank makes a move—miners, mineral and capital equipment stocks in the US get hard hit on fears that China will stop buying while Korean, Hong Kong, Japanese and Chinese equities often charge ahead. Are US portfolio managers the inmates running the great casino, er, asylum that is the US market? Or do they know something Asian investors do not? Probably a little of both. China is growing at nearly 10%; we are barely eking out 2% and much of that growth is thanks to Asia and other emerging markets. Should China successfully put the brakes on to a 7-8% growth rate, the economy in the US may well stall or even contract. Just think about where the miners, commodity and industrial companies have been getting their earnings growth of late—most of it has been in the Pacific Rim, not here. So we are tied to the hip with China but they are wearing a flotation vest while we still have a brick (called the National Debt) tied to our feet. If the PBOC is successful in curbing inflation, China may well keep its head above water but we could find ourselves drowning nevertheless. The lesson here is twofold: first, we had better hope that the Chinese are successful in engineering a soft landing and secondly, we should not extrapolate the behavior of the Chinese market during its tightening cycle with what might happen to our own once the Fed decides it is time to put on the brakes—remember, the drop from 10% to 8% is a lot less both in terms of percentage and economic impact than that from 3.5% to 2%.
Over the weekend the Chinese Central Bank ordered the State’s banks to set aside more cash reserves in an effort to curb lending and escalating inflation. This is the 4th such reserve increase this year alone and China’s largest banks will now have to hold 20.5% of their capital in cash reserves. The move comes on the back of the Bank’s April 6th benchmark interest rate hike, the 4th since the beginning of 2010, and was in response to Friday’s report that the Chinese economy had grown 9.7% year over year, higher than the projected 9.5%. Since the PBOC began its efforts to slow the Chinese economy in 2010, through a series of rate and reserve hikes, the economy has shown little to no signs of easing its rapid growth. The one sector of the economy that has shown some response is the Chinese property market, which was ostensibly the PBOC’s initial primary target. Since the tightening cycle began, the Chinese property market has cooled from its torrid pace of 2009-2010 yet it is still growing. The latest report shows residential property values up 6% so far in 2011, less than the 7% annual growth of 2010, and that number is expected to decline further into 2012.
One would expect, with such restrictive monetary policy, the Chinese equity markets, along with their Asian counterparts, would be heading south daily in anticipation of much weaker economic news ahead. Instead, the Shanghai Composite was up 22bps overnight and most other Asian markets were essentially flat. European markets, however, are down over 1% and US equity futures are pointing to a much lower opening. In fact, this is a pattern that has been repeated since late January and since that time the Shanghai Composite is up nearly 14%, besting both Europe and the US, all while China has been applying the brakes. Now, to the astute US equity investor, this might seem perverse. Surely, from past experience, we know that rising interest rates in the US are almost always associated with a decline in the stock market so why is the same not happening in China? In fact, a larger question is why are rate hikes in China having more of an effect on European and US markets than on its own?
There are several answers to this conundrum (we use this word purposefully). First, looking back at history, even in the US an initial round of rate hikes does little to bring down the equity markets. There are many explanations for this phenomenon but the reason is probably a combination of several factors: first, most rate hikes in the US are well telegraphed so the first few hikes are never a surprise; second is investors’ initial belief that that rate hikes will be modest and short in duration (remember “one and done?”); third is the inevitable initial cash flow out of fixed income securities and into equities, which serves to prop up the stock market in the short term; finally is the belief among many investors that the Federal Reserve is often late and can do little to effectively apply the brakes once the economy has begun to run—the old “Genie out of the bottle” analogy. Much of these same reasons may well apply to the current Chinese market. Surely, the PBOC’s tightening has come as no surprise and even though there is no Chinese Treasury money to flow into stocks, the currency has appreciated less than rates, keeping the export economy relatively strong and that, of course, feeds into the belief that the rate hikes will be ineffective in slowing economic growth. And even if the tightening is effective, what will be the new growth rate-- 8%? Still not bad given the valuations of Chinese equities. Chinese investors, as well, may not recall the PBOC’s last tightening cycle, which went overboard, throwing the economy into a recession, and so continue to doubt the efficacy of the Bank’s policies.
The ultimate question, of course, is why are the monetary policies of China having more of an affect of US markets (at least in the short run) than they are on Asian equities? We see this every time the Chinese Central Bank makes a move—miners, mineral and capital equipment stocks in the US get hard hit on fears that China will stop buying while Korean, Hong Kong, Japanese and Chinese equities often charge ahead. Are US portfolio managers the inmates running the great casino, er, asylum that is the US market? Or do they know something Asian investors do not? Probably a little of both. China is growing at nearly 10%; we are barely eking out 2% and much of that growth is thanks to Asia and other emerging markets. Should China successfully put the brakes on to a 7-8% growth rate, the economy in the US may well stall or even contract. Just think about where the miners, commodity and industrial companies have been getting their earnings growth of late—most of it has been in the Pacific Rim, not here. So we are tied to the hip with China but they are wearing a flotation vest while we still have a brick (called the National Debt) tied to our feet. If the PBOC is successful in curbing inflation, China may well keep its head above water but we could find ourselves drowning nevertheless. The lesson here is twofold: first, we had better hope that the Chinese are successful in engineering a soft landing and secondly, we should not extrapolate the behavior of the Chinese market during its tightening cycle with what might happen to our own once the Fed decides it is time to put on the brakes—remember, the drop from 10% to 8% is a lot less both in terms of percentage and economic impact than that from 3.5% to 2%.
Monday, April 11, 2011
Ramblings of a Portfolio Manager
Extra! Extra! Commodity Prices to Derail the Economy!
So say the popular financial news media, each and every day since oil broke $100 per barrel back in February on Mid East and African tensions. Scores of “analysts” have appeared on TV to tell us that $100, $110, $120, $125/bbl…well, you get it, is the “tipping point” (annoying resurrected economist slang for the straw that broke the camel’s back), which will send the US economy spiraling back into economic recession. A host of others have also appeared to tell us that copper, steel, corn, cotton and grain will pose a similar threat. We even had Saudi Arabia posit a $350-$300/bbl number should they face Libya’s fate (read, we want US forces and ordnance). Combined with the idiot politicians, who cannot come to terms on budget “cuts” (actually less of an increase but still an increase) that amount to 0.30% of this year’s annual budget and continued troubles in Japan, the “double dip” camp has reemerged as a potent voice on the airwaves. This time, however, they don’t have their stories well coordinated. The Commodity chickens fear commodity-induced inflation will crimp corporate margins, slowing hiring and killing the consumer, thus reducing earnings and throwing us back into recession. The Budget and Japan watchers (in league with the Euro-contagion conspiracists) argue that Japan’s weakness, European austerity and a Government shutdown will simply shave GDP growth estimates back to a point where job loss, rather that creation, will ensue. The outcome of either camp’s dire prediction is that our economy will slow, falling back into recession. Just recently Goldman Sachs trimmed their 2011 GDP forecast by a full percentage point, to 2.5%, a level inconsistent with job growth, based on all of the above fears—no sense in angering any one of the camps, all of whom cold be a potential client for Goldman’s next custom crafted special purpose vehicle. Are all these really bright folks correct? Has anyone ever done a real follow-up on Goldman’s stock-specific or economic calls? We have, they stink. So much for the “smartest guys in the room.”
Let’s throw out a few basic statistics. First of all, US inflation is 70% based on wages. 20% is commodity pricing. The rest is miscellaneous paper transfers and non-commodity spending. As many have lamented over the years, we don’t make anything anymore over here but lawyers and bankers. And right now those paper-pushers aren’t doing as well as the popular press would have you believe. There is still actually deflation in financial services with the continued surfeit of workers. Add in nation-wide U7, which is still above 15% and there is an overhang of people ready to enter the workforce but whom haven’t gotten “the call.” True, that overhang could hit like a Tsunami at any time, should US industry find productivity gains are no longer low hanging fruit, but for that to occur, GDP growth would have to be several percentage points higher than it is now—and that would signal a very, very strong economy, flying in the faces of the doomsayer scenarios we described above. We just aren’t there yet and capacity utilization (save for the Airlines who are desperately cutting back flights in the face of rising energy prices) is still just below a level that would signal additional hiring and capital investment.
Secondly, as we have often heard, consumer spending comprises a nice round number, also about, 70% of our GDP. For true economic weakness and a double dip to occur, we have to damage that consumer. Quick to respond, the Commodity guys point out that higher oil prices mean higher gasoline prices, which will slow consumer traffic. As a double whammy, when “she” gets to the mall, the consumer will find higher goods prices as the result of climbing cotton and other raw material inputs into the products purchased. In fact, there is already some evidence of “demand destruction,” the reduction of energy usage as a direct result of higher energy costs. Miles driven are down 3% year-over-year, according to AAA, and that can almost be directly related to higher energy prices. FedEx and UPS are raising shipping rates, hurting online sales as well (or at least the margins of the online retailers). But the argument that finished goods prices are rising is specious at best. Retailers are cutting, not raising prices for a host of goods from apparel to automobiles and amid those price reductions they are reporting record margins—why? Because the greatest input into manufacturing those products is labor, not commodities and labor in this country is highly flexible (still high usage of temps) and gaining no traction in pricing and manufacturers have learned flexible manufacturing techniques over the years, able to quickly move production to the lowest cost producing countries world-wide. The tech companies, hit with supply disruptions resulting from the Japan quake, are a prime example of this move to flexible manufacturing. Small wonder the Korean stock market has done so well of late—which stable, cheap labor country do you think benefits most?
Do we think the US will experience inflation over the next 2-3 years? Yes, of course. But not the hyper-inflation for which so many experts have been clamoring. QE2 will end and we just don’t see enough political resolve for a QE3. Prices will have to stand on their own after June and then we shall see. With no more downward pressure on the dollar, we would expect prices for commodities to fall. The offset is that US manufacturers will become less competitive world wide with the stronger currency but, as we have pointed out, the rest of the world (27% of S&P 500 earnings) is doing better than we are. So, perhaps, exporting our inflation (and higher margins) abroad will save corporate margins here. Next week we will start to see US corporations reporting Q1 earnings. We expect little or no impact on Q1 from either oil, Europe or the earthquake, which occurred late in the Quarter. Guidance and forward looking statements will be key to where the market heads over the next 6 months. However, as of last week, Corporate manager optimism was still at a recent high. Given all that has occurred over the world in the last two months, for that level of optimism to stand, we would expect guidance to be much better than expected and the market to move higher
So say the popular financial news media, each and every day since oil broke $100 per barrel back in February on Mid East and African tensions. Scores of “analysts” have appeared on TV to tell us that $100, $110, $120, $125/bbl…well, you get it, is the “tipping point” (annoying resurrected economist slang for the straw that broke the camel’s back), which will send the US economy spiraling back into economic recession. A host of others have also appeared to tell us that copper, steel, corn, cotton and grain will pose a similar threat. We even had Saudi Arabia posit a $350-$300/bbl number should they face Libya’s fate (read, we want US forces and ordnance). Combined with the idiot politicians, who cannot come to terms on budget “cuts” (actually less of an increase but still an increase) that amount to 0.30% of this year’s annual budget and continued troubles in Japan, the “double dip” camp has reemerged as a potent voice on the airwaves. This time, however, they don’t have their stories well coordinated. The Commodity chickens fear commodity-induced inflation will crimp corporate margins, slowing hiring and killing the consumer, thus reducing earnings and throwing us back into recession. The Budget and Japan watchers (in league with the Euro-contagion conspiracists) argue that Japan’s weakness, European austerity and a Government shutdown will simply shave GDP growth estimates back to a point where job loss, rather that creation, will ensue. The outcome of either camp’s dire prediction is that our economy will slow, falling back into recession. Just recently Goldman Sachs trimmed their 2011 GDP forecast by a full percentage point, to 2.5%, a level inconsistent with job growth, based on all of the above fears—no sense in angering any one of the camps, all of whom cold be a potential client for Goldman’s next custom crafted special purpose vehicle. Are all these really bright folks correct? Has anyone ever done a real follow-up on Goldman’s stock-specific or economic calls? We have, they stink. So much for the “smartest guys in the room.”
Let’s throw out a few basic statistics. First of all, US inflation is 70% based on wages. 20% is commodity pricing. The rest is miscellaneous paper transfers and non-commodity spending. As many have lamented over the years, we don’t make anything anymore over here but lawyers and bankers. And right now those paper-pushers aren’t doing as well as the popular press would have you believe. There is still actually deflation in financial services with the continued surfeit of workers. Add in nation-wide U7, which is still above 15% and there is an overhang of people ready to enter the workforce but whom haven’t gotten “the call.” True, that overhang could hit like a Tsunami at any time, should US industry find productivity gains are no longer low hanging fruit, but for that to occur, GDP growth would have to be several percentage points higher than it is now—and that would signal a very, very strong economy, flying in the faces of the doomsayer scenarios we described above. We just aren’t there yet and capacity utilization (save for the Airlines who are desperately cutting back flights in the face of rising energy prices) is still just below a level that would signal additional hiring and capital investment.
Secondly, as we have often heard, consumer spending comprises a nice round number, also about, 70% of our GDP. For true economic weakness and a double dip to occur, we have to damage that consumer. Quick to respond, the Commodity guys point out that higher oil prices mean higher gasoline prices, which will slow consumer traffic. As a double whammy, when “she” gets to the mall, the consumer will find higher goods prices as the result of climbing cotton and other raw material inputs into the products purchased. In fact, there is already some evidence of “demand destruction,” the reduction of energy usage as a direct result of higher energy costs. Miles driven are down 3% year-over-year, according to AAA, and that can almost be directly related to higher energy prices. FedEx and UPS are raising shipping rates, hurting online sales as well (or at least the margins of the online retailers). But the argument that finished goods prices are rising is specious at best. Retailers are cutting, not raising prices for a host of goods from apparel to automobiles and amid those price reductions they are reporting record margins—why? Because the greatest input into manufacturing those products is labor, not commodities and labor in this country is highly flexible (still high usage of temps) and gaining no traction in pricing and manufacturers have learned flexible manufacturing techniques over the years, able to quickly move production to the lowest cost producing countries world-wide. The tech companies, hit with supply disruptions resulting from the Japan quake, are a prime example of this move to flexible manufacturing. Small wonder the Korean stock market has done so well of late—which stable, cheap labor country do you think benefits most?
Do we think the US will experience inflation over the next 2-3 years? Yes, of course. But not the hyper-inflation for which so many experts have been clamoring. QE2 will end and we just don’t see enough political resolve for a QE3. Prices will have to stand on their own after June and then we shall see. With no more downward pressure on the dollar, we would expect prices for commodities to fall. The offset is that US manufacturers will become less competitive world wide with the stronger currency but, as we have pointed out, the rest of the world (27% of S&P 500 earnings) is doing better than we are. So, perhaps, exporting our inflation (and higher margins) abroad will save corporate margins here. Next week we will start to see US corporations reporting Q1 earnings. We expect little or no impact on Q1 from either oil, Europe or the earthquake, which occurred late in the Quarter. Guidance and forward looking statements will be key to where the market heads over the next 6 months. However, as of last week, Corporate manager optimism was still at a recent high. Given all that has occurred over the world in the last two months, for that level of optimism to stand, we would expect guidance to be much better than expected and the market to move higher
Monday, March 21, 2011
Ramblings of a Portfolio Manager
Bombs are Good for the Market?
“Sell on the trumpets, buy on the cannons” is an old Wall Street expression suggesting how to invest during armed conflict. It’s a reverse offshoot of the overly used “buy on the rumor, sell on the news” maxim and, despite its now trite status, the recommended behavioral anomaly seems to persist in the equity markets. It worked during Iraq’s invasion of Kuwait, during the US invasions of Afghanistan and Iraq, after Clinton used cruise missiles to kill a few camels and burn some Sudanese tents and an Aspirin factory and, given the status of market futures this morning, seems to be holding once again after allied missile strikes and bombing broke out in Libya over the weekend. The theory, as best we can define it, is that the reality of war is never so bad as the fear, fog and rumor leading up to it. In light of the above examples and Libya, that theory probably holds true especially given the asymmetrical powers of the opposing forces in all these recent cases.
Interesting, there is a lot more operating on the markets this morning than just hitting Libya with a few bombs. Japan seems to have stabilized their runaway reactors over the weekend, connecting power to drive water pumps and cool the core. That’s good news on the long road to resolving their ongoing post-quake reactor crisis and most likely is lightening some of the nuclear discount under which the markets have been trading of late. However, missed by the popular press was a statement issued by Japanese Prime Minister Kan, pledging to rebuild quickly and aiming to compile a relief and reconstruction package as soon as next month. Estimates for the cost of rebuilding effort run as high as $100 billion. That would also be good news not only for the Japanese people but for infrastructure companies both in Japan and abroad, a fact we pointed out last week. Not so well publicized was Saudi Arabia’s pledge to give out $36 billion (of our money) to its citizens to quell their thoughts of uprising. Also, not unlike the old joke about the reaction time of kicking a dinosaur in the tail, investors are also most likely coming to the realization that the Philly Fed Index released last week was very strong and that most banks passed the Fed’s Stress Test II on Friday and may now resume paying dividends. Both speak to the health and strength of our economy and its financial system. Putting it all together, the weekend navel contemplators have their buy orders in this morning. We wonder who makes money selling during panic and buying on euphoria.
In any case, the point of this week’s Ramblings is to look beyond the current world turmoil for signs of what it will all mean to the markets in the intermediate term, not just this morning, and opportunities presented therein. The last two weeks have seen oil and coal (and companies supplying both) rise on Mideast supply interruption fears and rumors of the early demise of Nuclear power. Stocks of Uranium producers have been decimated. Infrastructure plays only caught a bid on Friday after Larry Kudlow stated what we mentioned two days earlier—that the quake may benefit these companies. High-end retailers have gotten bombed as hard as Quadafi’s compound on fears of a pull-back in the Japanese tourist trade and, most perplexing of all, technology companies have been indiscriminately sold off on the belief that parts supply disruptions from Japan will crimp their earnings. How can one make money on these dislocations?
We like coal and oil, not so much for the temporary positives but for the long-term industrial and consumer need for these energy sources. Yes, US energy independence, solar, wind and other alternatives are wonderful dreams but, like Obama, Jimmy Carter had them too. We don’t know what to make of Uranium but 25 years ago we listened to a presentation by Alan Greenspan to the University Club in New York in which he predicted that the risks of Nuclear power may someday outweigh the risks of oil. We may be there now and that line of thinking will probably weigh on politicians for years to come. Plentiful and cheap coal will most likely slow the return to reactor building even in China. So Uranium is probably worth a miss for the not-so-stout-hearted. As for the other sectors hit by the turmoil, we believe that this is a great opportunity to pick from amid the market rubble. First of all, the indiscriminant selling of companies with supplies or sales wholly unconnected to Japan have given US investors an unprecedented gift. Secondly, even US companies somehow impacted by Japan have now been given a “bye,” meaning that whatever they report for the second and third quarters of this year, they will be able to blame it all on Japan, a one-time extraordinary event, rather than any kind of US economic weakness or company-specific issues. Any investors out there old enough to remember when El Niño was an excuse for missed estimates at everything from retailers to Caterpillar? It’s gonna happen again, trust us.
Some tech companies, like Alcatel Lucent and Texas Instruments, have already warned investors that supply disruptions will likely impact earnings for the upcoming quarters. For companies such as these, we suggest the buy on the rumor strategy, particularly for the tech companies. Yes, supplies will be interrupted in the short-term but demand (despite the trouble in Japan) will not. Prices will rise at the supplier end of the chain, giving those companies an earnings boost, and we should not underestimate their ability to quickly shift production to other locations (without publicly letting on), easing supply constraints but maintaining the higher prices. Beneficiaries of Japan’s ills are probably a good place to look but we caution that Japan’s insular, protectionist attitude has not been changed by this tragedy so they will look first to domestic companies before calling for help from the US and China. Still, let’s not forget that Libya will need some rebuilding and has no industry of its own—just ask the folks at Halliburton what Kuwait did for them. Indirect beneficiaries like commodity producers (steel, coking coal, aluminum, building supplies) are good places to look as Japan and Libya don’t have much in the way of their own raw material stocks and the Japanese producers, like steel plants, are currently off line due to power constraints and will be for some time. This list goes on. Interested investors should give us a call.
So, looking out into the next few quarters, we see many positives from US companies reporting earnings. Some will be directly benefited by recent world events; others will be negatively affected but given a free pass. Eventually oil should return to price levels commensurate with real demand, not war panic, giving the consumer a tax break and investors may finally start focusing on fundamentals, which are good, rather than headlines, which have been bad. All-in-all, then, we see the US equity markets rising from the recent ashes and would be buyers, although not on the euphoria of the moment. We have yet to return to pre-crises market levels and investors will be given another opportunity to get in before we do so. Remember, stocks take the stairs up but the elevator down—that gives prudent investors time to take advantage of the dislocations the recent negative headline events have produced.
“Sell on the trumpets, buy on the cannons” is an old Wall Street expression suggesting how to invest during armed conflict. It’s a reverse offshoot of the overly used “buy on the rumor, sell on the news” maxim and, despite its now trite status, the recommended behavioral anomaly seems to persist in the equity markets. It worked during Iraq’s invasion of Kuwait, during the US invasions of Afghanistan and Iraq, after Clinton used cruise missiles to kill a few camels and burn some Sudanese tents and an Aspirin factory and, given the status of market futures this morning, seems to be holding once again after allied missile strikes and bombing broke out in Libya over the weekend. The theory, as best we can define it, is that the reality of war is never so bad as the fear, fog and rumor leading up to it. In light of the above examples and Libya, that theory probably holds true especially given the asymmetrical powers of the opposing forces in all these recent cases.
Interesting, there is a lot more operating on the markets this morning than just hitting Libya with a few bombs. Japan seems to have stabilized their runaway reactors over the weekend, connecting power to drive water pumps and cool the core. That’s good news on the long road to resolving their ongoing post-quake reactor crisis and most likely is lightening some of the nuclear discount under which the markets have been trading of late. However, missed by the popular press was a statement issued by Japanese Prime Minister Kan, pledging to rebuild quickly and aiming to compile a relief and reconstruction package as soon as next month. Estimates for the cost of rebuilding effort run as high as $100 billion. That would also be good news not only for the Japanese people but for infrastructure companies both in Japan and abroad, a fact we pointed out last week. Not so well publicized was Saudi Arabia’s pledge to give out $36 billion (of our money) to its citizens to quell their thoughts of uprising. Also, not unlike the old joke about the reaction time of kicking a dinosaur in the tail, investors are also most likely coming to the realization that the Philly Fed Index released last week was very strong and that most banks passed the Fed’s Stress Test II on Friday and may now resume paying dividends. Both speak to the health and strength of our economy and its financial system. Putting it all together, the weekend navel contemplators have their buy orders in this morning. We wonder who makes money selling during panic and buying on euphoria.
In any case, the point of this week’s Ramblings is to look beyond the current world turmoil for signs of what it will all mean to the markets in the intermediate term, not just this morning, and opportunities presented therein. The last two weeks have seen oil and coal (and companies supplying both) rise on Mideast supply interruption fears and rumors of the early demise of Nuclear power. Stocks of Uranium producers have been decimated. Infrastructure plays only caught a bid on Friday after Larry Kudlow stated what we mentioned two days earlier—that the quake may benefit these companies. High-end retailers have gotten bombed as hard as Quadafi’s compound on fears of a pull-back in the Japanese tourist trade and, most perplexing of all, technology companies have been indiscriminately sold off on the belief that parts supply disruptions from Japan will crimp their earnings. How can one make money on these dislocations?
We like coal and oil, not so much for the temporary positives but for the long-term industrial and consumer need for these energy sources. Yes, US energy independence, solar, wind and other alternatives are wonderful dreams but, like Obama, Jimmy Carter had them too. We don’t know what to make of Uranium but 25 years ago we listened to a presentation by Alan Greenspan to the University Club in New York in which he predicted that the risks of Nuclear power may someday outweigh the risks of oil. We may be there now and that line of thinking will probably weigh on politicians for years to come. Plentiful and cheap coal will most likely slow the return to reactor building even in China. So Uranium is probably worth a miss for the not-so-stout-hearted. As for the other sectors hit by the turmoil, we believe that this is a great opportunity to pick from amid the market rubble. First of all, the indiscriminant selling of companies with supplies or sales wholly unconnected to Japan have given US investors an unprecedented gift. Secondly, even US companies somehow impacted by Japan have now been given a “bye,” meaning that whatever they report for the second and third quarters of this year, they will be able to blame it all on Japan, a one-time extraordinary event, rather than any kind of US economic weakness or company-specific issues. Any investors out there old enough to remember when El Niño was an excuse for missed estimates at everything from retailers to Caterpillar? It’s gonna happen again, trust us.
Some tech companies, like Alcatel Lucent and Texas Instruments, have already warned investors that supply disruptions will likely impact earnings for the upcoming quarters. For companies such as these, we suggest the buy on the rumor strategy, particularly for the tech companies. Yes, supplies will be interrupted in the short-term but demand (despite the trouble in Japan) will not. Prices will rise at the supplier end of the chain, giving those companies an earnings boost, and we should not underestimate their ability to quickly shift production to other locations (without publicly letting on), easing supply constraints but maintaining the higher prices. Beneficiaries of Japan’s ills are probably a good place to look but we caution that Japan’s insular, protectionist attitude has not been changed by this tragedy so they will look first to domestic companies before calling for help from the US and China. Still, let’s not forget that Libya will need some rebuilding and has no industry of its own—just ask the folks at Halliburton what Kuwait did for them. Indirect beneficiaries like commodity producers (steel, coking coal, aluminum, building supplies) are good places to look as Japan and Libya don’t have much in the way of their own raw material stocks and the Japanese producers, like steel plants, are currently off line due to power constraints and will be for some time. This list goes on. Interested investors should give us a call.
So, looking out into the next few quarters, we see many positives from US companies reporting earnings. Some will be directly benefited by recent world events; others will be negatively affected but given a free pass. Eventually oil should return to price levels commensurate with real demand, not war panic, giving the consumer a tax break and investors may finally start focusing on fundamentals, which are good, rather than headlines, which have been bad. All-in-all, then, we see the US equity markets rising from the recent ashes and would be buyers, although not on the euphoria of the moment. We have yet to return to pre-crises market levels and investors will be given another opportunity to get in before we do so. Remember, stocks take the stairs up but the elevator down—that gives prudent investors time to take advantage of the dislocations the recent negative headline events have produced.
Thursday, March 17, 2011
Ramblings of a Portfolio Manager
Interim Ramblings -- Japan
10 basis points of World GDP growth. That’s it. One tenth of one percent of world GDP is expected to be affected by the terrible tragedy in Japan. And that is in the short term. No one has yet to quantify the longer-term benefits to manufacturers and exporters in the US and China from the strengthening Yen and the enormous needs for building materials and equipment soon to be hitting the order books during Japan’s reconstruction phase. It sounds perverse (and cruel) to say but it is very true that this tragedy has become Japan’s own Economic Recovery and Rebuilding Act—similar to our own except that the funds will doubtless be channeled into needed, productive projects rather than the many worthless make-work boondoggles the current Administration has squandered our funds upon here. And US exporters might just be the beneficiaries.
The US currently imports one half of what it did from Japan just 10 years ago and while our exports have increased, estimates are that only about 2% of the S&P 500 earnings are dependent on that trade. And it is unclear if exports from the US will even drop off. True, some industries like auto parts may suffer but food, medicine, building materials and energy (oil, coal) may actually increase to satisfy immediate needs and to replace lost productive capacity. For example, Japanese steel and aluminum plants are offline or damaged and much of both of those commodities will be needed for reconstruction. So far many tech companies have announced supply disruptions but they remind us that these disruptions will only be temporary and are the result of power outages rather than damages. Furthermore, for some segments of the Tech Sector, the damage to Japan’s infrastructure should be a good thing down the road: First, competitors are eliminated from the market temporarily. Secondly, some sectors, like optical components, were in a glut prior to the quake—the disruption will help them work down inventories, eventually raising prices. Finally, when the rebuilding occurs, the repairs will most certainly include the Country’s technology infrastructure and that will be good for US Tech manufacturers. Multiply these factors across many US industrial sectors and you will see where we’re going.
US equity markets are trading on sentiment—fear of nuclear fallout and of economic disaster in Japan, fear of the Middle East burning and fear of European debt defaults. Yet we have lost only about 6% from the top on all major US equity indices. That’s not bad considering the spike in the VIX and the huge drop in investor sentiment. For those of you who have hit the sell button, we suggest a long bike ride, maybe a cocktail and some re-runs of Two and a Half Men rather than shivering in front of CNN or CNBC, pondering more sales. The images coming across TV and the minute-by-minute conflicting headlines are only a recipe for angst and making an investment mistake. As Warren Buffet is fond of saying, be greedy when others are fearful, be fearful when others are greedy. Right now, it sure looks to us that others are panicking. It may sound mercenary and vulture-like but we’re investors so we are taking advantage of the situation. We suggest that you do too—but before the TV talking heads figure out that this tragedy, in the long run, may be just what both Japan and the US need to pull our respective economies out of their current malaise.
Happy St. Patrick’s Day.
10 basis points of World GDP growth. That’s it. One tenth of one percent of world GDP is expected to be affected by the terrible tragedy in Japan. And that is in the short term. No one has yet to quantify the longer-term benefits to manufacturers and exporters in the US and China from the strengthening Yen and the enormous needs for building materials and equipment soon to be hitting the order books during Japan’s reconstruction phase. It sounds perverse (and cruel) to say but it is very true that this tragedy has become Japan’s own Economic Recovery and Rebuilding Act—similar to our own except that the funds will doubtless be channeled into needed, productive projects rather than the many worthless make-work boondoggles the current Administration has squandered our funds upon here. And US exporters might just be the beneficiaries.
The US currently imports one half of what it did from Japan just 10 years ago and while our exports have increased, estimates are that only about 2% of the S&P 500 earnings are dependent on that trade. And it is unclear if exports from the US will even drop off. True, some industries like auto parts may suffer but food, medicine, building materials and energy (oil, coal) may actually increase to satisfy immediate needs and to replace lost productive capacity. For example, Japanese steel and aluminum plants are offline or damaged and much of both of those commodities will be needed for reconstruction. So far many tech companies have announced supply disruptions but they remind us that these disruptions will only be temporary and are the result of power outages rather than damages. Furthermore, for some segments of the Tech Sector, the damage to Japan’s infrastructure should be a good thing down the road: First, competitors are eliminated from the market temporarily. Secondly, some sectors, like optical components, were in a glut prior to the quake—the disruption will help them work down inventories, eventually raising prices. Finally, when the rebuilding occurs, the repairs will most certainly include the Country’s technology infrastructure and that will be good for US Tech manufacturers. Multiply these factors across many US industrial sectors and you will see where we’re going.
US equity markets are trading on sentiment—fear of nuclear fallout and of economic disaster in Japan, fear of the Middle East burning and fear of European debt defaults. Yet we have lost only about 6% from the top on all major US equity indices. That’s not bad considering the spike in the VIX and the huge drop in investor sentiment. For those of you who have hit the sell button, we suggest a long bike ride, maybe a cocktail and some re-runs of Two and a Half Men rather than shivering in front of CNN or CNBC, pondering more sales. The images coming across TV and the minute-by-minute conflicting headlines are only a recipe for angst and making an investment mistake. As Warren Buffet is fond of saying, be greedy when others are fearful, be fearful when others are greedy. Right now, it sure looks to us that others are panicking. It may sound mercenary and vulture-like but we’re investors so we are taking advantage of the situation. We suggest that you do too—but before the TV talking heads figure out that this tragedy, in the long run, may be just what both Japan and the US need to pull our respective economies out of their current malaise.
Happy St. Patrick’s Day.
Monday, March 7, 2011
Ramblings of a Portfolio Manager
Why isn’t Higher Oil the Straw in the Proverbial Camel’s Back of the Market?
After two weeks of turmoil in the Middle East and Africa, the major US equity averages have moved very little. Since riots in Egypt broke out at the end of January NYMEX crude has risen approximately $21/bbl, from roughly $85 to $106, a nearly 25% increase. Gasoline prices at the pump have risen a more modest 10%, yet despite the hike in real costs to consumers and the flood of negative press and television images, the Dow and S&P 500 have only declined by about 2% respectively from their highs. In fact, both indices are now trading exactly where they were at the end of January, when all this turmoil broke out in the first place. The spike in oil, naturally, has drawn pundits from out of the woodwork declaring potential economic Armageddon from higher oil, quoting such sensitivity numbers as a $2 per share impact in S&P earnings per every $20/bbl rise in oil. We don’t have the economic inputs for the model nor the Cray computer to run them to test this assertion so we’ll just take if for gospel (dangerous, we know). Based on current 2011 S&P earnings estimates of about $93 per share, that $2 would be roughly a 2.2% decline in corporate earnings for this year. Assuming no multiple contraction, that would equate to about 29 S&P or 270 Dow points, which would put us back just to where the markets were at the end of January, when all this began--that just so happens to be where we are right now!. Of course, with decline corporate earnings, one would expect some multiple compression resulting from the attendant dampening of investor sentiment. At the current multiple of the S&P 500, 14.2, a full multiple point of compression (pretty high historically) would equate to another 7% decline in the index. Combined with the prognosticated reduced corporate earnings power, that would give us the 10% decline that “everyone” is expecting as a pullback. A decline of that magnitude would just bring us back to about December 1st in the S&P 500.
But the tradeoff between oil prices, GDP and stock market levels is not rigidly formulaic. There are a number of variables that impact market levels in a rising energy market and make for a dynamic situation that, in reality, no economist or oil company executive (let alone a politician) can predict. For example, investor sentiment, which at the beginning of February was at a level that just about every talking head on TV who could emerge from under a rock proclaimed signaled a market pullback, has dropped significantly. According to AAII, the percentage of investors who are now bullish is nearly equal to those that are bearish at 36% vs. 32%. This is down from a level of nearly 52% bullishness at the beginning of February, just as the oil region turmoil began. The contrarian in us likes this move, especially in light of the relatively small decline in market averages.
Another factor that goes into the GDP vs. market level vs. energy price tradeoff is the impact at the consumer level, something the TV pundits like to take throw out continually. Here, simple math that even we can do throws this argument into doubt. According to the NHTSA, the average American drives 15,000 miles per year. According to the DOT, the average fuel consumption of all cars, light trucks and SUVs on the road today is 21.4 miles per gallon. Since the rioting began, gasoline at the pump is up, on average, about $0.33/ per gallon. Simple math tells us that the impact per average driver would be about $231 per year IF these higher gas prices persist for another year or more. Now, $231 may not seem like a lot to Wall Street types but it can be meaningful to the average American, at the margin. However, taking an adage from Wall Street, “nothing cures high oil prices like high oil prices.” That means, in basic economic terms, as gasoline prices climb, demand, being elastic, declines, thus reducing the per-family dollar impact and, eventually, bringing down the price of the commodity. The latest data we have on this phenomenon is from March 2008, when gas prices reached highs we are currently seeing at the pump. At that time, the number of miles driven dropped 4.3% in response, according to the Federal Highway Administration. Right now, even though oil has jumped 25%, stockpiles (you’ve heard all about Cushing and the spare oil sitting around in tankers in harbors around the world) have kept the pump price impact to half of that and will probably do so for several months. And that pump price needs to stay here for another 12 months before we see any significant impact to the average driver. At that point, miles driven will most likely decline, negating some of the impact. But we have a long time for stockpiles to be reduced (remember, ONLY 1.8% of the world’s supply has been cut and that has only seen a 50% reduction). In the meantime a situation such as we saw in 2007 and 2008, a significant move to more online shopping, will further negate the impact to consumers and consumer-related companies.
Of course, the GDP impact of higher oil isn’t just dependent upon consumers’ driving and spending habits. Energy is also used for home heating and transportation of goods, in addition to manufacturing (think plastics). On the first point, the Northern Hemisphere is now entering Spring/Summer. Heating demands will plummet, lessening both demand and the impact to consumer wallets. Transportation (trucking, rails, airlines, etc.) has gotten much more efficient over the last decade, further lessening the impact to the economy versus prior oil shocks. Our manufacturing economy has become both more efficient in energy use but has also transformed over the years. In fact, the dollar output of GDP per unit (BTU) of energy consumption has almost halved since 2000, according to the US Census Bureau. Simply put, our economy, despite all the hand wringing by opposing political parties, has indeed become less energy dependent as it has transformed from manufacturing to high-tech and financial services. Another 70’s style oil shock may well have a GDP impact but it can be expected to be much, much less in terms of reduction of domestic output.
The quoted $2/share S&P earnings impact per $20/bbl in oil presumes a permanent upward spike in oil to that higher level. So far, we have had only two weeks of rising oil and the new, higher price has not arrived all at once—it has been a steady incline. Except for airlines and other energy sensitive transportation industries, few US companies have yet felt the bit of higher oil. And, unless this new level of crude remains permanent or rises further, we believe few will. Right now a 25% rise in oil based on a 0.9% decline in supply says to us that there is a big “contagion premium” built into in oil prices right now. That premium probably assumes several Middle East countries undergo what Libya is now seeing, but probably not Saudi Arabia. A lot needs to go wrong in the Middle East for that scenario to develop—a fairly low probability, in our opinion. One thing we have to stress, though, is that all this turmoil represents a disruption, not destruction in supply. The length of this disruption is anybody’s guess but you can be sure that, as economies wholly dependent upon selling the black sticky stuff, the oil producing nations will ensure that it is as short as possible—or their troubles will only compound. That says to us that the price of oil has most likely over-reacted to current world events and that the equity markets have reacted rationally. Now that investor sentiment is low and oil is high, when we get a reversal of both (which we will and they will come together) the base will be set for much higher equity markets.
After two weeks of turmoil in the Middle East and Africa, the major US equity averages have moved very little. Since riots in Egypt broke out at the end of January NYMEX crude has risen approximately $21/bbl, from roughly $85 to $106, a nearly 25% increase. Gasoline prices at the pump have risen a more modest 10%, yet despite the hike in real costs to consumers and the flood of negative press and television images, the Dow and S&P 500 have only declined by about 2% respectively from their highs. In fact, both indices are now trading exactly where they were at the end of January, when all this turmoil broke out in the first place. The spike in oil, naturally, has drawn pundits from out of the woodwork declaring potential economic Armageddon from higher oil, quoting such sensitivity numbers as a $2 per share impact in S&P earnings per every $20/bbl rise in oil. We don’t have the economic inputs for the model nor the Cray computer to run them to test this assertion so we’ll just take if for gospel (dangerous, we know). Based on current 2011 S&P earnings estimates of about $93 per share, that $2 would be roughly a 2.2% decline in corporate earnings for this year. Assuming no multiple contraction, that would equate to about 29 S&P or 270 Dow points, which would put us back just to where the markets were at the end of January, when all this began--that just so happens to be where we are right now!. Of course, with decline corporate earnings, one would expect some multiple compression resulting from the attendant dampening of investor sentiment. At the current multiple of the S&P 500, 14.2, a full multiple point of compression (pretty high historically) would equate to another 7% decline in the index. Combined with the prognosticated reduced corporate earnings power, that would give us the 10% decline that “everyone” is expecting as a pullback. A decline of that magnitude would just bring us back to about December 1st in the S&P 500.
But the tradeoff between oil prices, GDP and stock market levels is not rigidly formulaic. There are a number of variables that impact market levels in a rising energy market and make for a dynamic situation that, in reality, no economist or oil company executive (let alone a politician) can predict. For example, investor sentiment, which at the beginning of February was at a level that just about every talking head on TV who could emerge from under a rock proclaimed signaled a market pullback, has dropped significantly. According to AAII, the percentage of investors who are now bullish is nearly equal to those that are bearish at 36% vs. 32%. This is down from a level of nearly 52% bullishness at the beginning of February, just as the oil region turmoil began. The contrarian in us likes this move, especially in light of the relatively small decline in market averages.
Another factor that goes into the GDP vs. market level vs. energy price tradeoff is the impact at the consumer level, something the TV pundits like to take throw out continually. Here, simple math that even we can do throws this argument into doubt. According to the NHTSA, the average American drives 15,000 miles per year. According to the DOT, the average fuel consumption of all cars, light trucks and SUVs on the road today is 21.4 miles per gallon. Since the rioting began, gasoline at the pump is up, on average, about $0.33/ per gallon. Simple math tells us that the impact per average driver would be about $231 per year IF these higher gas prices persist for another year or more. Now, $231 may not seem like a lot to Wall Street types but it can be meaningful to the average American, at the margin. However, taking an adage from Wall Street, “nothing cures high oil prices like high oil prices.” That means, in basic economic terms, as gasoline prices climb, demand, being elastic, declines, thus reducing the per-family dollar impact and, eventually, bringing down the price of the commodity. The latest data we have on this phenomenon is from March 2008, when gas prices reached highs we are currently seeing at the pump. At that time, the number of miles driven dropped 4.3% in response, according to the Federal Highway Administration. Right now, even though oil has jumped 25%, stockpiles (you’ve heard all about Cushing and the spare oil sitting around in tankers in harbors around the world) have kept the pump price impact to half of that and will probably do so for several months. And that pump price needs to stay here for another 12 months before we see any significant impact to the average driver. At that point, miles driven will most likely decline, negating some of the impact. But we have a long time for stockpiles to be reduced (remember, ONLY 1.8% of the world’s supply has been cut and that has only seen a 50% reduction). In the meantime a situation such as we saw in 2007 and 2008, a significant move to more online shopping, will further negate the impact to consumers and consumer-related companies.
Of course, the GDP impact of higher oil isn’t just dependent upon consumers’ driving and spending habits. Energy is also used for home heating and transportation of goods, in addition to manufacturing (think plastics). On the first point, the Northern Hemisphere is now entering Spring/Summer. Heating demands will plummet, lessening both demand and the impact to consumer wallets. Transportation (trucking, rails, airlines, etc.) has gotten much more efficient over the last decade, further lessening the impact to the economy versus prior oil shocks. Our manufacturing economy has become both more efficient in energy use but has also transformed over the years. In fact, the dollar output of GDP per unit (BTU) of energy consumption has almost halved since 2000, according to the US Census Bureau. Simply put, our economy, despite all the hand wringing by opposing political parties, has indeed become less energy dependent as it has transformed from manufacturing to high-tech and financial services. Another 70’s style oil shock may well have a GDP impact but it can be expected to be much, much less in terms of reduction of domestic output.
The quoted $2/share S&P earnings impact per $20/bbl in oil presumes a permanent upward spike in oil to that higher level. So far, we have had only two weeks of rising oil and the new, higher price has not arrived all at once—it has been a steady incline. Except for airlines and other energy sensitive transportation industries, few US companies have yet felt the bit of higher oil. And, unless this new level of crude remains permanent or rises further, we believe few will. Right now a 25% rise in oil based on a 0.9% decline in supply says to us that there is a big “contagion premium” built into in oil prices right now. That premium probably assumes several Middle East countries undergo what Libya is now seeing, but probably not Saudi Arabia. A lot needs to go wrong in the Middle East for that scenario to develop—a fairly low probability, in our opinion. One thing we have to stress, though, is that all this turmoil represents a disruption, not destruction in supply. The length of this disruption is anybody’s guess but you can be sure that, as economies wholly dependent upon selling the black sticky stuff, the oil producing nations will ensure that it is as short as possible—or their troubles will only compound. That says to us that the price of oil has most likely over-reacted to current world events and that the equity markets have reacted rationally. Now that investor sentiment is low and oil is high, when we get a reversal of both (which we will and they will come together) the base will be set for much higher equity markets.
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