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.
Saturday, May 28, 2011
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.
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