What More Does the Market Want?
We just ended a second consecutive week during which an enormous amount of potentially positive market moving data was released. Two weeks ago we got strong earnings and forward guidance from the likes of Alcoa, CSX, GE and Intel, heard of a Goldman Sachs settlement with the SEC and learned that BP may have successfully capped its leaking well in the Gulf. Last week we saw continuing positive news: the Financial Regulation Bill was passed by the Senate and signed into law by the President, relieving much of the uncertainty surrounding the bill especially when in the final analysis the rules may take up to a decade to be implemented by which time affected firms will have adapted to or circumvented them; the results of the European bank stress tests were released, results that were much, much better than expected both in terms of the number of firms that passed and capital that needed to be raised; housing start data was in line with expectations but new permits were better than expected; weekly jobless claims came in more or less in line and the Senate approved an extension of unemployment insurance, restoring benefits to 2.5 million people; Fed Chairman Bernanke testified on Capitol Hill that the Fed does not see a double dip and maintains its 3%+ GDP growth forecast but is in no rush to hike rates and is ready to implement “QE2” should growth slow; General Electric hiked its dividend earlier than expected, a sign that they see strength in their business going forward and, finally, the string of strong corporate earnings and raised forward guidance continued with the who’s who of the Fortune 500 reporting including IBM, Microsoft, American Express, Coca Cola, Apple, UPS and Ford. The markets responded positively to this data with the Dow and S&P 500 both rallying about 2.3% over the last two weeks. This rally, however, was very choppy (markets initially dropped over 1.5% on Bernanke’s testimony) and still leaves us negative for the year with the Dow down 1% and the S&P 500 just below the flat line.
With all the positive news and dissipation of uncertainty during the last two weeks, the major market indexes still sit in the red for the year. What will it take for investors to feel comfortable enough to get back into the market and move us higher? Last week we opined on the dichotomy between the economic data and company reports. A more accurate depiction, it now appears, is reality vs. the forecasts of economists—i.e. the view from the trenches vs. that from the Ivory Tower. We reiterate our belief that the best prognosticators of the Country’s economic future are its CEOs and not politically (or otherwise) motivated egg heads, most of whom have never held a real job. Still, with all the positive chatter coming out of Corporate America, the markets languish. What more do they want?
We believe that there is one remaining piece to the puzzle, or conundrum in Alan Greenspan speak, and that is jobs. Though companies have painted a rosy outlook for their future profits, most have done so with the assumption of no new hiring. Clearly, for the markets to advance, unemployment must come down, which means these companies must incorporate additional staffing into their forecasts. Two factors are going to cause them to do this: first, their businesses must improve to the point where they cannot possibly grow Earnings Per Share fast enough to meet Wall Street expectations without brining in new workers—i.e. capacity utilization must increase to the point where productivity gains alone (i.e. using more technology or working existing employees harder) will not suffice to drive earnings higher. We believe that many companies are getting to that point right now. Just this morning Federal Express hiked its guidance, saying that they expect volumes to grow 20% this year. Given that their planes are already nearly full, they will have to add new planes, and people to fill and fly them, to meet this growth. We’ve heard similar reports from other industries, who are also beginning to ramp their capacity utilization.
The second factor that will spur hiring feeds into the first, and it involves the reduction of uncertainty regarding Government policy—both on taxes and regulation. Companies will hire when business improves but only if they are confident in estimating the marginal cost of those hires. Right now, given the uncertainty over the cost of health care reform, new taxes in 2011 and any other fiat of regulation that Congress decides to ram through between now and November, that marginal cost of hiring is almost impossible to estimate. For the future to be sufficiently clear to give CEOs the green light to hire, we are going to need a radical change in policy/behavior on Capitol Hill and the only way to achieve that is to get some good old fashioned gridlock, or better yet complete regime change, in Congress. Poll any CEO and it is highly probable that you will hear the belief that we currently have the most anti-business Government in this nation’s history occupying our seats on Capitol Hill. This isn’t necessarily our opinion—it’s a message we have consistently heard from virtually every earnings conference call we have attended—and it is a line of thinking that doesn’t encourage Managements to hire. Fortunately, the mid-term elections are only a little more than three months away and we will be getting early data from the political polls very soon. Given that markets are discounting mechanisms, this means that if the polling data shows CEOs will be getting their wish this election, then we can see continued equity gains through the fall. Let’s just hope that the “dead men walking” on Capitol Hill don’t pull the same tricks as the Corzine administration did to New Jersey just before it was ejected on its ear last fall—that is, ramming through more tax and spend policies at the 11th hour. Hopefully, those soon-to-be lame ducks will start thinking about their futures in the private sector and exercise some spending restraint for a change.
Monday, July 26, 2010
Monday, July 19, 2010
Ramblings of a Portfolio Manager
The Great Wrestling Match--Top Down vs. Bottom Up. Who Will Win? So Far it’s the Guy Fighting with the Rear View Mirror
Last week earnings season officially kicked off with reports from Alcoa, Intel and several banks. The results were dramatically different than expected…in fact they were much, much better than we or most of Wall Street had anticipated. Second quarter earnings came in as expected—stronger than expected (why does no-one ever mention the paradox in that oft-repeated phrase?)—but the guidance, which every market watcher had expected to be downbeat, was surprisingly strong. In fact both Alcoa and Intel, our two cyclical reporters, guided most of their financial metrics higher for the rest of the year. That was not what the market was expecting. The reports initially continued the market rally that had begun the week earlier: a rally which in truth had begun not in anticipation of such positive results but due to relief that Europe is not melting down and is addressing its myriad problems in a semi-rational manner (e.g. the bank stress tests). Alcoa and Intel were frosting on a cake that had already been baked. By the end of the week JPMorgan and Bank America had reported similar results with credit quality improving amid tepid loan growth and weak trading revenues. Not stellar results, but not the disaster the markets had been expecting, especially in the wake of the Financial Reform bill, which had threatened and distracted bank Management throughout most of the quarter.
The week was full of other positive news as well. BP appeared to have successfully capped its well in the Gulf (unexpectedly), Goldman Sachs settled its fight with the SEC for half of what was anticipated (unexpectedly), without having to subject itself to a show trial, and jobless claims came in lower than expected. With all this positive, unexpected news, the major indices ended the week down -1%+. Huh? Despite the prior week’s rally based, as we indicated, on bullishness on Europe, one would have expected a continued strong market. We didn’t get one and the answer lies in several economic indicators released during the week: the Empire State Manufacturers Survey and the Philly Fed Index. Both came in weaker than expected, indicating that the economy did indeed take a pause in June, and the markets decided to focus on those data points rather than the comments and outlook of company management.
With two conflicting sets of data to analyze, on which one should we rely? Let’s take a quick look at the two culprits behind last week’s decline. The Empire Manufacturer’s Survey is a very narrow survey in which New York manufacturing companies are asked to estimate the percentage changes in their sales and employment levels from year to year (2009 to 2010 in the most recent case)—both year to date and for the calendar year. In addition to being narrow, it’s a backward looking indicator, which largely reports what has happened in New York-based businesses over the last month with little commentary on expectations for the future. Last week’s survey indicated that conditions for New York manufacturers continued to improve in July, but that the pace of growth in business activity slowed substantially over the prior month (June). The new orders and shipments indexes were also positive but lower than last month’s levels and the employment indexes dipped as well, with the average work week index falling below zero for the first time this year. The future general business conditions index component was little changed, remaining close to its May and June levels but below the highs seen earlier in the year. Most of the other components of the index were also positive, but were below the peak levels reached in May. As for the forward-looking part, the median respondent reported that sales were up 7 percent for the first half of 2010 and were expected to be up 8 percent for the full calendar year, indicating continued positive growth. The release of this report on Wednesday dampened the continuation of the rally sparked by Intel and Alcoa.
The Philly Fed survey has been conducted since 1968 by the Philadelphia Federal Reserve Bank and questions manufacturers in the Third Federal Reserve District (Pennsylvania, New Jersey and Delaware) on general business conditions. It comprises a blend of manufacturing sectors and general businesses. The survey is conducted in the vein of the Purchasing Managers Index (PMI) report and has a rather high correlation with that report; it questions participants about their outlook on things such as employment, new orders, shipments, inventories and prices paid. Answers are given in the form of "better", "worse" or "same" as the previous month, and, as with the PMI, results are used to construct an index, only this index uses a median value for expansion of 0, rather than 50. The Philly Fed Report signals expansion when it is above zero and contraction when below thus a higher Philadelphia Fed Survey figure indicates a positive outlook from manufacturers, suggesting increased production. So what did Friday’s survey reveal that sent the markets down so sharply?
Results from the Survey released on Friday suggest that regional manufacturing activity continues to expand in July but has slowed over the past two months. Surveyed firms reported a decline in new orders this month compared with June. Employment showed a slight improvement this month. The survey’s broad indicators of future activity continue to suggest that the region’s manufacturing executives expect growth in business over the next six months, but optimism has waned notably in recent months. The future general activity index remained positive for the 19th consecutive month but fell to its lowest reading in 16 months. The future new orders and shipments indexes also declined notably, falling 22 and 13 points, respectively. For the 15th consecutive month, the percentage of firms expecting employment to increase over the next six months (30 percent) exceeded the percentage expecting declines (17 percent).
How do we rationalize these economic reports with what companies have said so far this quarter First, they all tell us something we already knew—that business conditions slowed in May and June. The combination of fears of a European meltdown, uncertainty surrounding the Government’s attack on financial institutions and the expiration of the Federal Housing Purchase Tax Credit, among other things, caused the consumer and some small businesses, at least, to temporarily put on the brakes. This information should have already been discounted in the markets’ 10%+ slide from its April highs. Secondly, and more interestingly, however, they show a dichotomy between what management is saying about the future in the survey responses versus what they are saying on earnings conference calls. The Empire State Survey is largely backward looking and thus says little about what its small collection of firms is thinking about the future. The Philly Fed survey, however, encompasses a larger number of firms from a broader spectrum of businesses and the outlook from this survey was somewhat more dour than what we have been hearing from company management. How do we explain that? There are several reasons, we believe. First, the Philly Fed Survey is still somewhat narrow in its geographic and business line focus versus the component companies of the S&P 500. Secondly, they are also somewhat smaller and have less foreign sales as well. Finally, the questions asked regarding the future are quite narrow versus the “free association” latitude given company management on conference calls. So what we are hearing from the survey respondents is still a narrow outlook as compared with the likes given by Alcoa, Intel or the banks. IBM and the rest of the technology companies, scheduled to report this week, will further broaden the economic commentary.
How does an investor make sense of this all? Should we believe company management, whom we all know can be promotional about their stocks, or the government reports, some of which encompass the very same companies that have given rosier outlooks on conference calls? Frankly, our money is on company management. First of all, the surveys contain a very large, rearward looking component to them. We all know that May and June were slow, as does a market down12% from its April high. Secondly, while management can say whatever they like to a government survey taker, they are making very public comments, to which they will be held, when they give earnings and sales guidance on conference call. Additionally, management teams have learned over the years that the game is to guide so as to set a low bar that will be easier to beat in the upcoming quarter. So, if anything, management guidance on conference calls to date has been conservative rather than promotional. If that’s the case, then the Q3 2010 may be even stronger than analysts have “estimated” already. Just remember, a rear view mirror may be a great way to kill the mythical medusa but given that markets are anticipatory beasts, it isn’t a good way to invest.
Last week earnings season officially kicked off with reports from Alcoa, Intel and several banks. The results were dramatically different than expected…in fact they were much, much better than we or most of Wall Street had anticipated. Second quarter earnings came in as expected—stronger than expected (why does no-one ever mention the paradox in that oft-repeated phrase?)—but the guidance, which every market watcher had expected to be downbeat, was surprisingly strong. In fact both Alcoa and Intel, our two cyclical reporters, guided most of their financial metrics higher for the rest of the year. That was not what the market was expecting. The reports initially continued the market rally that had begun the week earlier: a rally which in truth had begun not in anticipation of such positive results but due to relief that Europe is not melting down and is addressing its myriad problems in a semi-rational manner (e.g. the bank stress tests). Alcoa and Intel were frosting on a cake that had already been baked. By the end of the week JPMorgan and Bank America had reported similar results with credit quality improving amid tepid loan growth and weak trading revenues. Not stellar results, but not the disaster the markets had been expecting, especially in the wake of the Financial Reform bill, which had threatened and distracted bank Management throughout most of the quarter.
The week was full of other positive news as well. BP appeared to have successfully capped its well in the Gulf (unexpectedly), Goldman Sachs settled its fight with the SEC for half of what was anticipated (unexpectedly), without having to subject itself to a show trial, and jobless claims came in lower than expected. With all this positive, unexpected news, the major indices ended the week down -1%+. Huh? Despite the prior week’s rally based, as we indicated, on bullishness on Europe, one would have expected a continued strong market. We didn’t get one and the answer lies in several economic indicators released during the week: the Empire State Manufacturers Survey and the Philly Fed Index. Both came in weaker than expected, indicating that the economy did indeed take a pause in June, and the markets decided to focus on those data points rather than the comments and outlook of company management.
With two conflicting sets of data to analyze, on which one should we rely? Let’s take a quick look at the two culprits behind last week’s decline. The Empire Manufacturer’s Survey is a very narrow survey in which New York manufacturing companies are asked to estimate the percentage changes in their sales and employment levels from year to year (2009 to 2010 in the most recent case)—both year to date and for the calendar year. In addition to being narrow, it’s a backward looking indicator, which largely reports what has happened in New York-based businesses over the last month with little commentary on expectations for the future. Last week’s survey indicated that conditions for New York manufacturers continued to improve in July, but that the pace of growth in business activity slowed substantially over the prior month (June). The new orders and shipments indexes were also positive but lower than last month’s levels and the employment indexes dipped as well, with the average work week index falling below zero for the first time this year. The future general business conditions index component was little changed, remaining close to its May and June levels but below the highs seen earlier in the year. Most of the other components of the index were also positive, but were below the peak levels reached in May. As for the forward-looking part, the median respondent reported that sales were up 7 percent for the first half of 2010 and were expected to be up 8 percent for the full calendar year, indicating continued positive growth. The release of this report on Wednesday dampened the continuation of the rally sparked by Intel and Alcoa.
The Philly Fed survey has been conducted since 1968 by the Philadelphia Federal Reserve Bank and questions manufacturers in the Third Federal Reserve District (Pennsylvania, New Jersey and Delaware) on general business conditions. It comprises a blend of manufacturing sectors and general businesses. The survey is conducted in the vein of the Purchasing Managers Index (PMI) report and has a rather high correlation with that report; it questions participants about their outlook on things such as employment, new orders, shipments, inventories and prices paid. Answers are given in the form of "better", "worse" or "same" as the previous month, and, as with the PMI, results are used to construct an index, only this index uses a median value for expansion of 0, rather than 50. The Philly Fed Report signals expansion when it is above zero and contraction when below thus a higher Philadelphia Fed Survey figure indicates a positive outlook from manufacturers, suggesting increased production. So what did Friday’s survey reveal that sent the markets down so sharply?
Results from the Survey released on Friday suggest that regional manufacturing activity continues to expand in July but has slowed over the past two months. Surveyed firms reported a decline in new orders this month compared with June. Employment showed a slight improvement this month. The survey’s broad indicators of future activity continue to suggest that the region’s manufacturing executives expect growth in business over the next six months, but optimism has waned notably in recent months. The future general activity index remained positive for the 19th consecutive month but fell to its lowest reading in 16 months. The future new orders and shipments indexes also declined notably, falling 22 and 13 points, respectively. For the 15th consecutive month, the percentage of firms expecting employment to increase over the next six months (30 percent) exceeded the percentage expecting declines (17 percent).
How do we rationalize these economic reports with what companies have said so far this quarter First, they all tell us something we already knew—that business conditions slowed in May and June. The combination of fears of a European meltdown, uncertainty surrounding the Government’s attack on financial institutions and the expiration of the Federal Housing Purchase Tax Credit, among other things, caused the consumer and some small businesses, at least, to temporarily put on the brakes. This information should have already been discounted in the markets’ 10%+ slide from its April highs. Secondly, and more interestingly, however, they show a dichotomy between what management is saying about the future in the survey responses versus what they are saying on earnings conference calls. The Empire State Survey is largely backward looking and thus says little about what its small collection of firms is thinking about the future. The Philly Fed survey, however, encompasses a larger number of firms from a broader spectrum of businesses and the outlook from this survey was somewhat more dour than what we have been hearing from company management. How do we explain that? There are several reasons, we believe. First, the Philly Fed Survey is still somewhat narrow in its geographic and business line focus versus the component companies of the S&P 500. Secondly, they are also somewhat smaller and have less foreign sales as well. Finally, the questions asked regarding the future are quite narrow versus the “free association” latitude given company management on conference calls. So what we are hearing from the survey respondents is still a narrow outlook as compared with the likes given by Alcoa, Intel or the banks. IBM and the rest of the technology companies, scheduled to report this week, will further broaden the economic commentary.
How does an investor make sense of this all? Should we believe company management, whom we all know can be promotional about their stocks, or the government reports, some of which encompass the very same companies that have given rosier outlooks on conference calls? Frankly, our money is on company management. First of all, the surveys contain a very large, rearward looking component to them. We all know that May and June were slow, as does a market down12% from its April high. Secondly, while management can say whatever they like to a government survey taker, they are making very public comments, to which they will be held, when they give earnings and sales guidance on conference call. Additionally, management teams have learned over the years that the game is to guide so as to set a low bar that will be easier to beat in the upcoming quarter. So, if anything, management guidance on conference calls to date has been conservative rather than promotional. If that’s the case, then the Q3 2010 may be even stronger than analysts have “estimated” already. Just remember, a rear view mirror may be a great way to kill the mythical medusa but given that markets are anticipatory beasts, it isn’t a good way to invest.
Monday, July 12, 2010
Ramblings of a Portfolio Manager
It’s Summer—Good Time To Have a Nice BOD
Earnings season “officially” kicks off this evening with the arrival of Alcoa’s second quarter earnings report. The talking heads in the financial media have been analyzing this season and its relative importance to the markets for weeks now. The general consensus is that, while second quarter earnings will be strong—perhaps even stronger than expected—guidance from most management teams will be cautious to tepid at best. Europe, the ongoing anti-business attitude from the Obama Administration and the prospect of higher taxes next year are all to blame for the expected downbeat guidance. Of course, as most investors are aware, the market discounts what it expects to happen, not what has already happened and so if Management guidance is poor, then we can expect stocks to fall further. Or can we?
As we have mentioned, the financial press has been talking about this earnings season for weeks now—ever since the market started to swoon in May. As CNBC said this morning, the sentiment and expectations are “awful going into this reporting season.” Comments like that signal to us that, most likely, the markets are already discounting the poor guidance everyone is talking about. With the major indices all down over 10% from their April highs, one can make the case that quite a bit of negative news has already been baked into current stock prices. Furthermore, with all the talk on the airwaves and internet about the expectations for guidance, it is hard to believe that there is anyone remotely interested in the capital markets who isn’t already braced for bad news.
We believe that the market is setting up for a good “buy on the dips” opportunity in stocks. We’re not necessarily talking about buying on dips in the equity market overall so much as buying on the dips that may occur in the first hours or days of trading in stocks that have just reported, with Management giving weak guidance. “But wait!” you say. We just said a fair amount of negative news is already in the stocks. Might they not actually jump on weak but not disastrous guidance? Perhaps, however, at the margin there is always a hair trigger trader or two in a stock with wishful thinking regarding an earnings report. We suspect that many stocks will have initial drops upon weak Management commentary, analyst downgrades (they love to downgrade a stock after the bad news comes out—saves them work on hard forward-looking research) and earnings cuts but that most will recover within a relatively short time—perhaps in some cases the same day. We’ve seen this type of behavior before—most recently in March-April of 2009, which became a signal that all the bad news was in the market. Not that we’re suggesting another 60-70% post-earnings season rally, just that this time around, a nice BOD might just make you some money.
Earnings season “officially” kicks off this evening with the arrival of Alcoa’s second quarter earnings report. The talking heads in the financial media have been analyzing this season and its relative importance to the markets for weeks now. The general consensus is that, while second quarter earnings will be strong—perhaps even stronger than expected—guidance from most management teams will be cautious to tepid at best. Europe, the ongoing anti-business attitude from the Obama Administration and the prospect of higher taxes next year are all to blame for the expected downbeat guidance. Of course, as most investors are aware, the market discounts what it expects to happen, not what has already happened and so if Management guidance is poor, then we can expect stocks to fall further. Or can we?
As we have mentioned, the financial press has been talking about this earnings season for weeks now—ever since the market started to swoon in May. As CNBC said this morning, the sentiment and expectations are “awful going into this reporting season.” Comments like that signal to us that, most likely, the markets are already discounting the poor guidance everyone is talking about. With the major indices all down over 10% from their April highs, one can make the case that quite a bit of negative news has already been baked into current stock prices. Furthermore, with all the talk on the airwaves and internet about the expectations for guidance, it is hard to believe that there is anyone remotely interested in the capital markets who isn’t already braced for bad news.
We believe that the market is setting up for a good “buy on the dips” opportunity in stocks. We’re not necessarily talking about buying on dips in the equity market overall so much as buying on the dips that may occur in the first hours or days of trading in stocks that have just reported, with Management giving weak guidance. “But wait!” you say. We just said a fair amount of negative news is already in the stocks. Might they not actually jump on weak but not disastrous guidance? Perhaps, however, at the margin there is always a hair trigger trader or two in a stock with wishful thinking regarding an earnings report. We suspect that many stocks will have initial drops upon weak Management commentary, analyst downgrades (they love to downgrade a stock after the bad news comes out—saves them work on hard forward-looking research) and earnings cuts but that most will recover within a relatively short time—perhaps in some cases the same day. We’ve seen this type of behavior before—most recently in March-April of 2009, which became a signal that all the bad news was in the market. Not that we’re suggesting another 60-70% post-earnings season rally, just that this time around, a nice BOD might just make you some money.
Tuesday, July 6, 2010
Ramblings of a Portfolio Manager
'08 or '82?
U.S. stocks plunged last week, giving the Dow first seven-day loss since 2008. The culprits: reports of slower-than-estimated growth in jobs and factory orders and concern that China’s economy has slowed. The Dow, S&P 500 and Russell 2000 are now respectively 14%, 16% and 19% off their April 23rd highs. Another day like Friday and the Russell will be in Bear Market territory for 2010. So far this year, bond returns have exceeded stock gains by the widest margin in nine years. Not exactly how strategists had hoped the first half of the year would unfold.
At the end of last week pessimism in the equity markets was almost as high as it was when Lehman went down in 2008. In fact, the one through 10-year Treasuries ended the week yielding less than they did in mid-late September of 2008, when Lehman failed and AIG required a minimum of $85 billion in government support to stave off a collapse of the entire financial system. Memories of those times are fresh, however, and as investors wonder what will be the next shoe to drop they are dumping equities wholesale and running to the “safety” of US Treasuries, ignoring the perils of that strategy. As one portfolio manager said, “It’s like running under a tree during a thunderstorm.”
Let us say categorically that this is NOT 2008 by any stretch of the imagination although right now the equity markets are acting like it. Back then we had a true credit seizure—banks weren’t lending to other banks, one-month LIBOR rates, currently at 0.35%, exceeded 4% and even GE couldn't roll its commercial paper. We hate to use the phrase but, yes, this time is different…very different. What we have now is a softening in the labor market after a rebound off the bottom which was due in part to Fiscal stimulus. The market, always forward-looking, is ratcheting down its growth expectations—but the expectations are for growth nonetheless. In late 2008 we were staring over a precipice, wondering whether banks would open the next day, let alone how low S&P 500 earnings were going to fall. As of the end of April, S&P earnings expectations were for $100 for 2011, an all time high. Even a drastic cut of 20% would bring them back to late 2005/early 2006 levels when the equity markets were much higher than they are now. The trouble is the uncertainty factor and that is currently depressing multiples on what are declining earnings estimates—a double whammy to stock prices. Unfortunately, the uncertainty comes from our own government. The President and Congress, rather than showing concern for a U6 unemployment number hovering near 17%, are busy punishing Goldman Sachs with 2000 pages of worthless regulation. The only part of the Government that investors trust right now is Bernanke and the Federal Reserve and they are somewhat handcuffed right now given what the fools in Congress are doing. That will change, of course, and the winds are already blowing that way. But no one wants to wait until November to see how many of them get kicked out.
In our opinion, this market looks a lot more like it did in 1982 than 2008. Back in ’82, the Economy was emerging from a deep recession and growth was rapid. The Federal Reserve, seeing the 8%+ growth in GDP and having just come through a terrible period of inflation, started hiking rates too quickly. That move—too much too soon-- sent the Economy right back into recession. The markets followed in lock step and we had two back-to-back bear markets. We don’t expect that to happen this time. We have a Federal Reserve Chairman who is a student of history and not about to repeat the mistakes of the past. One mantra often heard is that the Fed is out of bullets---rubbish! The Fed can still re-instate Quantitative Easing and most likely they will, given that there is no inflation in sight. At current rates homes will sell again and there is a good chance that the home buyers tax credit will come back. Republicans will gain votes in Congress in November and the benefits from European debt-cutting measures will become clear as the year progresses. All this says to us that the markets may be setting up for a strong rally through the end of the year.
Basically we have hit the reset button after a nice run from last year and now have the same opportunities to make money as we did last spring. Investors just need to be patient, wait for the bottom and get back in—psychologically difficult we recognize, but this is where and how fortunes are made. It isn’t often that the markets hand you a second opportunity to make big money but, we believe, they are fast doing so again. No-one knows where and when the bottom will come—any day we could get news that China has taken its foot off the brakes, that the US or Europe is doing Quantitative Easing or some other positive news. Given the state of pessimism, it won’t take much. Frankly, earnings season has such low expectations, even that could initiate the turn. Just a little factoid: the S&P and Dow are now just 10% or less above where they were at the height of the AIG and Lehman crisis yet the situation is clearer, the uncertainty less and we have a strong domestic policy for growth and recovery already in place. Earnings estimates are 50% higher too. The uncertainty is much less yet the markets have barely moved. We like the way things are setting up and even though picking the precise bottom is tricky, we suggest investors begin averaging into the market now, while prices are depressed.
U.S. stocks plunged last week, giving the Dow first seven-day loss since 2008. The culprits: reports of slower-than-estimated growth in jobs and factory orders and concern that China’s economy has slowed. The Dow, S&P 500 and Russell 2000 are now respectively 14%, 16% and 19% off their April 23rd highs. Another day like Friday and the Russell will be in Bear Market territory for 2010. So far this year, bond returns have exceeded stock gains by the widest margin in nine years. Not exactly how strategists had hoped the first half of the year would unfold.
At the end of last week pessimism in the equity markets was almost as high as it was when Lehman went down in 2008. In fact, the one through 10-year Treasuries ended the week yielding less than they did in mid-late September of 2008, when Lehman failed and AIG required a minimum of $85 billion in government support to stave off a collapse of the entire financial system. Memories of those times are fresh, however, and as investors wonder what will be the next shoe to drop they are dumping equities wholesale and running to the “safety” of US Treasuries, ignoring the perils of that strategy. As one portfolio manager said, “It’s like running under a tree during a thunderstorm.”
Let us say categorically that this is NOT 2008 by any stretch of the imagination although right now the equity markets are acting like it. Back then we had a true credit seizure—banks weren’t lending to other banks, one-month LIBOR rates, currently at 0.35%, exceeded 4% and even GE couldn't roll its commercial paper. We hate to use the phrase but, yes, this time is different…very different. What we have now is a softening in the labor market after a rebound off the bottom which was due in part to Fiscal stimulus. The market, always forward-looking, is ratcheting down its growth expectations—but the expectations are for growth nonetheless. In late 2008 we were staring over a precipice, wondering whether banks would open the next day, let alone how low S&P 500 earnings were going to fall. As of the end of April, S&P earnings expectations were for $100 for 2011, an all time high. Even a drastic cut of 20% would bring them back to late 2005/early 2006 levels when the equity markets were much higher than they are now. The trouble is the uncertainty factor and that is currently depressing multiples on what are declining earnings estimates—a double whammy to stock prices. Unfortunately, the uncertainty comes from our own government. The President and Congress, rather than showing concern for a U6 unemployment number hovering near 17%, are busy punishing Goldman Sachs with 2000 pages of worthless regulation. The only part of the Government that investors trust right now is Bernanke and the Federal Reserve and they are somewhat handcuffed right now given what the fools in Congress are doing. That will change, of course, and the winds are already blowing that way. But no one wants to wait until November to see how many of them get kicked out.
In our opinion, this market looks a lot more like it did in 1982 than 2008. Back in ’82, the Economy was emerging from a deep recession and growth was rapid. The Federal Reserve, seeing the 8%+ growth in GDP and having just come through a terrible period of inflation, started hiking rates too quickly. That move—too much too soon-- sent the Economy right back into recession. The markets followed in lock step and we had two back-to-back bear markets. We don’t expect that to happen this time. We have a Federal Reserve Chairman who is a student of history and not about to repeat the mistakes of the past. One mantra often heard is that the Fed is out of bullets---rubbish! The Fed can still re-instate Quantitative Easing and most likely they will, given that there is no inflation in sight. At current rates homes will sell again and there is a good chance that the home buyers tax credit will come back. Republicans will gain votes in Congress in November and the benefits from European debt-cutting measures will become clear as the year progresses. All this says to us that the markets may be setting up for a strong rally through the end of the year.
Basically we have hit the reset button after a nice run from last year and now have the same opportunities to make money as we did last spring. Investors just need to be patient, wait for the bottom and get back in—psychologically difficult we recognize, but this is where and how fortunes are made. It isn’t often that the markets hand you a second opportunity to make big money but, we believe, they are fast doing so again. No-one knows where and when the bottom will come—any day we could get news that China has taken its foot off the brakes, that the US or Europe is doing Quantitative Easing or some other positive news. Given the state of pessimism, it won’t take much. Frankly, earnings season has such low expectations, even that could initiate the turn. Just a little factoid: the S&P and Dow are now just 10% or less above where they were at the height of the AIG and Lehman crisis yet the situation is clearer, the uncertainty less and we have a strong domestic policy for growth and recovery already in place. Earnings estimates are 50% higher too. The uncertainty is much less yet the markets have barely moved. We like the way things are setting up and even though picking the precise bottom is tricky, we suggest investors begin averaging into the market now, while prices are depressed.
Monday, June 28, 2010
Ramblings of a Portfolio Manager
To Some, Economics is Just Crap
It has come to our attention that some readers were actually disappointed by the omission of last week’s Ramblings, which was due wholly to our well deserved Father’s Day hiatus. We want you to know that the kids actually encouraged us to publish the piece despite the reverential holiday and even gave us the fodder for the pen. So, out of respect to the young ones, we will publish, at least in part, a commentary on a very sophisticated, insightful and potentially highly useful economic indicator that they stumbled upon while cruising Google Finance (yes, they are that weird).
Now, no doubt many have heard the urban legend of the hemline indicator as a stock market barometer. That old chestnut goes something to the effect that the more affluent and confident Americans feel, the higher women’s hemlines will rise as will, in tandem, the stock market. If true it is, of course, a coincident indicator that probably can be traced back to the roaring twenties when flappers prowled the speakeasies and good old Jack Kennedy Sr. ruled the booze and manipulated the markets. Interestingly, just last week the Chairman of a well-known apparel manufacturer was discussing on CNBC the “heel height” indicator as working in similar fashion (pun intended). In his humble opinion the confidence of Americans can be prognosticated by the height of women’s heels. Not to be outdone, however, our kids have advanced the “toilet paper indicator” as a check on the well-being of the consumer.
Stumbling upon an MSN Money report, they “discovered” what most of us already know; the US economy is dependent upon consumer spending and economists go to great lengths to measure the health of the consumer using the strength of shoppers as a proxy. But what most of the over-educated egg-heads tend to miss is that some of the most obvious and intuitive indicators are sales trends for simple, everyday products--for example, toilet paper. Think about it. Toilet paper is the one consumer product that everyone literally spends money on so they can flush it down the drain. So for consumers to upgrade their toilet tissue, they sure as heck must be feeling confident in their economic status; if they shift from one-ply to two-ply and, gasp, even three-ply they are, in fact, sending a signal on the state of their perceived financial well being. So what does the TPI tell us? According to RISI, a forest products industry research provider, US tissue production is up 13% so far in 2010, due solely to an increase in demand. This is after it plunged dramatically along with the economy and stock market in late 2008 and early 2009. Lending credence to the trend, Procter & Gamble recently reported mid-teens growth for their Charmin Brand (all without Mr. Whipple!) and noted that consumers are moving back toward higher-priced discretionary items after a long focus on value. We confess to not yet having done our research on fashion trends at Christian Dior or Jimmy Choo but from our limited research, to date, it appears to us that the US economy is indeed, still on a roll. [Rimshot]
OK, we actually meant to target this piece on the upcoming earnings season. There has been much handwringing in the financial press over what level of forward guidance companies will give during their second quarter conference calls, which have just begun. Most analysts are quite sure that second quarter earnings will surpass printed expectations on both the top and bottom lines but are becoming increasingly pessimistic about what Management will say about Q3 and beyond. So far we only have a handful of samples, mostly from technology companies, and they have been mixed. Oracle beat expectations, raised guidance and gave an optimistic outlook. Research in Motion barely squeaked by and was fairly dour in their forecast. We have to chalk up both cases to “company specific” issues (gee, it’s fun to sound like a real Wall Street sell side analyst!). In the case of Oracle, they are in the middle of a long-delayed corporate upgrade cycle. As for RIMM, the I-Phone and the mass of smart-phone competitors now crowding the market are stealing their share and putting pressure on prices--as an example, poor old Nokia, with no good offering, was a disaster of an earnings report last week. So what can we expect from the bulk of companies yet to report? Frankly, we have to go with the analysts this time around. It’s hard to imagine any company Management sticking their collective necks out with so much turmoil going on in the currency markets and economies around the world. There is just no upside in being a hero on a conference call—not unless you have 100% certainty that things are going to be rosy and what company ever has that?
So should you run out and sell all your US equity holdings? It’s probably a little late for that. The US equity markets, having corrected nearly 12-15% from their April peaks, are now pretty much discounting a lot of bad news on the forward-looking earnings front. The two and ten-year Treasuries yielding less today than what they did the day Lehman went bust attests to that fact. That’s not to say that individual stocks may not still take a nose dive on really bad guidance, however, in our opinion the equity markets as a collective whole have already priced in a good deal of bad news. Who really expects Alcoa, perennially the cyclical earnings report front-runner, to report stellar earnings (they have whiffed the last two quarters already) or give upbeat guidance? Does anyone think the US multi-nationals with large Euro exposure will say positive things about the next few quarters? Do you believe that the US banks, still parsing through the 1900 pages of regulatory vomit heaved upon them by a soon-to-be Lame Duck Congress, will have ebullient things to say about their earnings future? We sure don’t and neither, we believe, do other investors. Looking at the mutual fund flows, it’s pretty clear that the individual investor has fled equities yet again, so what is left in the stock market are the big institutions who are mandated to be invested. The hedge funds have sold what they want to sell and are short what they want to be short. Every institutional investor is braced for a bad earnings guidance season. There just isn’t a whole lot of optimism in the equity markets right now. We like the odds this scenario presents.
Yes, you could invest your money safely in Treasuries for the next two years and pull down a guaranteed hefty 65bps in annual return (that’s roughly 5/8th of one percent for you English majors). Or you could be a gambler and go out 10 years for a full 3.12% (pre-tax). Yeah, we know that those are guaranteed returns and a damned sight better than what you got out of equities between April 23rd and last Friday. But the lousy returns in equities over the last two months is now rear view mirror stuff. Investing is all about what to expect in and do about the future. For us, with pessimism regarding the economy and equities at an 18-month high and US bond yields at a two-year low (including the 2008 financial crisis) the odds overwhelmingly favor equities going forward. But as the kids say, just take a lot of Charmin with you as it may be a bumpy ride—better yet, 3-ply Quilted Northern as things just aren’t that bad.
It has come to our attention that some readers were actually disappointed by the omission of last week’s Ramblings, which was due wholly to our well deserved Father’s Day hiatus. We want you to know that the kids actually encouraged us to publish the piece despite the reverential holiday and even gave us the fodder for the pen. So, out of respect to the young ones, we will publish, at least in part, a commentary on a very sophisticated, insightful and potentially highly useful economic indicator that they stumbled upon while cruising Google Finance (yes, they are that weird).
Now, no doubt many have heard the urban legend of the hemline indicator as a stock market barometer. That old chestnut goes something to the effect that the more affluent and confident Americans feel, the higher women’s hemlines will rise as will, in tandem, the stock market. If true it is, of course, a coincident indicator that probably can be traced back to the roaring twenties when flappers prowled the speakeasies and good old Jack Kennedy Sr. ruled the booze and manipulated the markets. Interestingly, just last week the Chairman of a well-known apparel manufacturer was discussing on CNBC the “heel height” indicator as working in similar fashion (pun intended). In his humble opinion the confidence of Americans can be prognosticated by the height of women’s heels. Not to be outdone, however, our kids have advanced the “toilet paper indicator” as a check on the well-being of the consumer.
Stumbling upon an MSN Money report, they “discovered” what most of us already know; the US economy is dependent upon consumer spending and economists go to great lengths to measure the health of the consumer using the strength of shoppers as a proxy. But what most of the over-educated egg-heads tend to miss is that some of the most obvious and intuitive indicators are sales trends for simple, everyday products--for example, toilet paper. Think about it. Toilet paper is the one consumer product that everyone literally spends money on so they can flush it down the drain. So for consumers to upgrade their toilet tissue, they sure as heck must be feeling confident in their economic status; if they shift from one-ply to two-ply and, gasp, even three-ply they are, in fact, sending a signal on the state of their perceived financial well being. So what does the TPI tell us? According to RISI, a forest products industry research provider, US tissue production is up 13% so far in 2010, due solely to an increase in demand. This is after it plunged dramatically along with the economy and stock market in late 2008 and early 2009. Lending credence to the trend, Procter & Gamble recently reported mid-teens growth for their Charmin Brand (all without Mr. Whipple!) and noted that consumers are moving back toward higher-priced discretionary items after a long focus on value. We confess to not yet having done our research on fashion trends at Christian Dior or Jimmy Choo but from our limited research, to date, it appears to us that the US economy is indeed, still on a roll. [Rimshot]
OK, we actually meant to target this piece on the upcoming earnings season. There has been much handwringing in the financial press over what level of forward guidance companies will give during their second quarter conference calls, which have just begun. Most analysts are quite sure that second quarter earnings will surpass printed expectations on both the top and bottom lines but are becoming increasingly pessimistic about what Management will say about Q3 and beyond. So far we only have a handful of samples, mostly from technology companies, and they have been mixed. Oracle beat expectations, raised guidance and gave an optimistic outlook. Research in Motion barely squeaked by and was fairly dour in their forecast. We have to chalk up both cases to “company specific” issues (gee, it’s fun to sound like a real Wall Street sell side analyst!). In the case of Oracle, they are in the middle of a long-delayed corporate upgrade cycle. As for RIMM, the I-Phone and the mass of smart-phone competitors now crowding the market are stealing their share and putting pressure on prices--as an example, poor old Nokia, with no good offering, was a disaster of an earnings report last week. So what can we expect from the bulk of companies yet to report? Frankly, we have to go with the analysts this time around. It’s hard to imagine any company Management sticking their collective necks out with so much turmoil going on in the currency markets and economies around the world. There is just no upside in being a hero on a conference call—not unless you have 100% certainty that things are going to be rosy and what company ever has that?
So should you run out and sell all your US equity holdings? It’s probably a little late for that. The US equity markets, having corrected nearly 12-15% from their April peaks, are now pretty much discounting a lot of bad news on the forward-looking earnings front. The two and ten-year Treasuries yielding less today than what they did the day Lehman went bust attests to that fact. That’s not to say that individual stocks may not still take a nose dive on really bad guidance, however, in our opinion the equity markets as a collective whole have already priced in a good deal of bad news. Who really expects Alcoa, perennially the cyclical earnings report front-runner, to report stellar earnings (they have whiffed the last two quarters already) or give upbeat guidance? Does anyone think the US multi-nationals with large Euro exposure will say positive things about the next few quarters? Do you believe that the US banks, still parsing through the 1900 pages of regulatory vomit heaved upon them by a soon-to-be Lame Duck Congress, will have ebullient things to say about their earnings future? We sure don’t and neither, we believe, do other investors. Looking at the mutual fund flows, it’s pretty clear that the individual investor has fled equities yet again, so what is left in the stock market are the big institutions who are mandated to be invested. The hedge funds have sold what they want to sell and are short what they want to be short. Every institutional investor is braced for a bad earnings guidance season. There just isn’t a whole lot of optimism in the equity markets right now. We like the odds this scenario presents.
Yes, you could invest your money safely in Treasuries for the next two years and pull down a guaranteed hefty 65bps in annual return (that’s roughly 5/8th of one percent for you English majors). Or you could be a gambler and go out 10 years for a full 3.12% (pre-tax). Yeah, we know that those are guaranteed returns and a damned sight better than what you got out of equities between April 23rd and last Friday. But the lousy returns in equities over the last two months is now rear view mirror stuff. Investing is all about what to expect in and do about the future. For us, with pessimism regarding the economy and equities at an 18-month high and US bond yields at a two-year low (including the 2008 financial crisis) the odds overwhelmingly favor equities going forward. But as the kids say, just take a lot of Charmin with you as it may be a bumpy ride—better yet, 3-ply Quilted Northern as things just aren’t that bad.
Monday, June 14, 2010
Ramblings of a Portfolio Manager
Changing Course
We’ve been criticized for being overly bullish on equities over the last few weeks, paradoxically by institutional brokers who only make money when stocks are going up and investors are willing to buy. But smart brokers use charts, knowing full-well that they can’t count on their own in-house research to even call the direction of the wind during a hurricane, and the charts always tell you to hate stocks when they are going down and to love them when they are going up. Stocks have been going down of late so who are we to fight the tape with such weak arguments as valuation, fundamentals, and economic growth? That being the case, we bow to the chartists, throw in the towel and present here 10 reasons why you should NOT own stocks.
- Gold. It pays no dividend, costs you a great deal to hold, store and insure the physical asset (assuming you have a safe at home) and carries a 20%+ commission each way on trading it. But it’s going up and the chart guys say that means it’s going up. Sell stocks, buy gold. Someday you will be rich.
- Obama. His administration is anti big banks, anti business, fond of high taxes, espouses non-growth producing social programs, and has produced no growth in jobs in his 17 months in office. This, of course, is all information that very few are aware of. All these qualities, naturally, are so popular with the voters that he and the incumbents in Congress are virtually assured of a massive sweep in the mid-term and 2012 presidential elections. We even hear talk of suspending term limits so we may have these excellent statesmen in office forever! Sell stocks.
- BP. While the environmental impact is saddening, no one is sure if there will be a measurable economic impact from the spill in the gulf. BP isn’t in any US stock index so it can go to zero without affecting the indices here but we get to see that belching oil on TV every day and that has to be bad. Sell stocks.
- Uninspiring retail sales. Yup, 70% of our economy is based on the consumer and the latest round of retail sales reports showed only modest growth. So we shall join in with the bears and proclaim the US consumer dead for the 9,378th time in the last decade. Sell stocks.
- Yields on the 10-Year US Treasuries are now a fat 3.28%. That’s almost a hefty 200 basis points above expected inflation according to the current 10-year TIPS. And, of course, we know that the price of gold isn’t saying ANYTHING about expected inflation (just the super-attractiveness of that asset class). Sell stocks, place a penny into Treasuries (not a bank, the Government tells us they are bad) and sit tight in anticipation of the 2020 Bentley (lighter fuse) you will be able to buy with all those guaranteed accrued interest earnings ten years hence.
- Portugal. The rating agencies tell us things are bad there and those agencies employ some of the smartest, most forward thinking experts on Wall Street. And Portugal’s GDP is massive-- almost as big as Arizona’s! This is news. Sell stocks.
- Italy. The rating agencies haven’t yet told us things are bad there so things are OK. But if they do downgrade Italy, Sell stocks.
- Greece. The ratings agencies tell us things are bad there too. This is also news. Sell stocks.
- Spain. Ditto
- No-one wants to own stocks now. We all know the herd is always correct. Go with the herd. Sell stocks.
By the way, if you decoded our acronym, give us a call for this week’s picks.
Tuesday, June 1, 2010
Ramblings of a Portfolio Manager
How to Position Yourself Amid European Turmoil. 
According to the databases, the S&P500 just experienced its worst May performance since 1962 while the Dow had its worst May since 1940 and we have
OK, now you can examine the chart below.
The answer, other than the obvious fact that you would have wanted to avoid the Spanish stock market, is that it almost didn’t matter in which developed, Eurozone-affected equity market you invested your money last month—you would have lost a similar amount of money in any of them. The conundrum, however, is that the equity market of one of the most vulnerable countries to a PIGS debacle, France, outperformed almost all of the equity markets in May while stocks in China, with the strongest economy, no debt and the reserves to stimulate, underperformed all but Spain. The FTSE, in a worse position than the
What to make of this all? Of course this data is all backward-looking but it can give us a clue as to how some markets will perform for the rest of the year. First, we agree with the view that the export-minded EU countries are a buy right now. Several major investment banks have upgraded growth expectations for the stronger, export driven European economies over the past month as did the OECD last week. Secondly, we believe that the sell-off in smaller, US-focused countries is way overdone and that, going forward, they will outperform the large, US multinationals with significant European/currency exposure, especially if the Federal Reserve keeps a rate hike on extended hold, which we think will happen. The stronger dollar will continue to lure overseas investors to our markets and while some of that money will find its way into Treasuries is will also go into perceived “Euro-free” stocks, favoring small caps. Finally, though we have been dead wrong on the Chinese market this year, we have been correct on their economy and we believe that the Central Government will reverse their tightening course as soon as the measures appear to be working (which, as of this morning, they seem to be), especially in light of current world weakness, making Chinese stocks worth a serious look now, after a 20% slide year to date.
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