Ramblings of a Portfolio Manager

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.