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.
Monday, March 21, 2011
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.
Monday, February 21, 2011
Ramblings of a Portfolio Manager
Is the Inflation Boogie Man Really Hiding in Ben Bernanke’s Beard?
Since the Fed embarked on its second round of quantitative easing back in mid-November, economists, portfolio managers and politicians alike have appeared on TV to argue whether the program is an effective stimulant to the US economy in the long-run and whether the end-result would be much higher levels of inflation in the short-term. Here we examine the inflation argument.
One faction of the inflation camp argues that loose monetary policy is a recipe for runaway price rises as it raises the demand for consumption and capital investment, often in projects that would be uneconomical under a normal monetary regime—the old “demand-pull” cause of inflation from the text books. An opposition group, the “don’t worry just yet” camp, however, have argued in favor of the classic Phillips Curve theory, that inflation is directly related to the level of employment in an economy and that there is a historical inverse relationship between the rate of unemployment and the rate of inflation. This “cost-push” textbook inflation, they believe, is unrelated to monetary policy and is far off given the persistently high levels of U3 (the official unemployment rate, hovering around 9%) and, especially, U6 (total unemployed, plus all persons marginally attached to the labor force, plus total employed part time for economic reasons, as a percent of the civilian labor force plus all persons marginally attached to the labor force—currently 16.1%) labor underutilization. Yet a third group, in the inflation camp, the “competition for resources” faction, has postulated that surging commodity prices (in part related to the weak dollar from QE2 but also directly tied to insatiable demand from fast-growing emerging markets) will export inflation to our shores regardless of easy money or tight labor. In this scenario, monetary policy is somewhat responsible for the level of prices as it drives up demand for commodities, thus raising the costs of raw materials to producers and food, energy and other necessities to consumers, but the rest of the world is the real culprit behind inflation, rates and money supply independent.
Whom should we believe in this heated and ongoing debate? To begin, there is some basis to support the inflationary camp’s position that loose money will ultimately result in inflation. The rise in the money supply, combined with no change in the output of goods and services, can create a situation where there is an elastic and excess supply of money chasing a relatively inelastic supply of “wants.” The result is, at the margin, the prices of those “wants” will increase, driving inflation. Where this theory falls short is that output, in the longer run, is fairly elastic as companies can increase capacity, explore for more natural resources, etc. Money alone doesn’t drive inflation, it is the consumers’ demand for that money and the things it can buy paired off against the producers’ ability to supply that demand. Currently, capacity utilization in the US is around 76%, about 10 percentage points below the normal rate of an economy at full output, and has slightly contracted in the last few months. Over the years, both the level of capacity utilization and the rate of change in capacity utilization have been good predictors of future inflation. Right now, neither indicator is pointing in the right direction, suggesting that even though demand for consumption and investment may be rising there is still sufficient slack in production capacity and the interest to increase it to keep inflation at bay for the time being.
As for the Phillips Curve crowd, there is evidence that employment levels can manipulate inflation in the short run. In the US services account for almost 80% of GDP, when Federal, state and local governments are included. As a result, labor costs are nearly 70% of total input prices to the economy. Any uptick in demand for labor, therefore, would seem likely to produce much higher costs to business and, thus, inflation. The Curve predicts an upward “death spiral” as lower unemployment produces a lower supply of workers and the higher wages they are able to demand further increases want of goods and services, thus causing companies to need to expand capacity and employment further. The dynamics of the Phillips Curve are complex and there has been much debate on its efficacy in predicting inflation over the long run, at which it has not done well. Many have argued that we need to get below a “natural rate of unemployment” (one that includes those perpetually in search of different employment or who just don’t want to work) before the demand for labor requires companies bid up the price to attract employees. Still others have argued that, over the long run, workers price their compensation to exactly match the rate of inflation, eliminating the upward “death spiral” the Curve prophesizes. The “stagflation” of the 70’s attests to the limitations of the Phillips Curve.
Finally, the commodity price theory has some basis but a number of drawbacks. As we mentioned, the stagflation of the 70s is an example where inflation was imported in the form of higher oil prices from OPEC while the economy sat with relatively high levels of unemployment. There is nothing to suggest that scenario cannot happen again, given the current turmoil in the Mideast, however, the 70’s OPEC embargo was an exogenous, manipulation of supply which turned out to be temporary. The world is a much different place in the current decade and though we have not reduced our addiction to imported oil, we have a much more flexible and diversified economy in which substitution can mitigate rising commodities prices (we’re already seeing such examples as aluminum replacing copper as those prices surge and abundant solar, nat gas and coal replacing more expensive oil). In addition, as we mentioned, services drive this economy, not manufacturing; raw materials comprise only about 5% of input costs. Inflation is an economic condition in which all prices rise, not just some. So we have a long way to go before the commodity alarmists’ dire predictions become of concern.
The ultimate question in predicting inflation is whether manufacturers will be able to pass the higher costs they incur (from whatever source) on to consumers. On Wednesday the Labor Department released the core producer price index, which excludes food and energy costs. It increased 0.5 percent in January, the biggest advance since October of 2008. Economists had expected a 0.2 percent gain. Most of the rise, however, reflected a jump in drug prices, which accounted for 40 percent of the increase and probably reflected a one-time price hike ahead of the implementation of Obamacare. The overall, non-core number, reinstating food and energy prices, rose a more hefty 0.8 percent, lending credence to the commodities inflation argument. This advance followed increases of 0.9 percent in December and 0.7 percent in November and marks the seventh straight rise in prices. These numbers represent costs to manufacturers. As we said, the ability to pass them on to consumers will ultimately determine whether we get inflation. On Thursday the BLS released the Consumer Price Index. The CPI increased 0.4 percent in January on a seasonally adjusted basis, half the level of the PPI. Moreover, increases in indexes for energy, commodities and for food accounted for over two thirds of the all items increase giving further support to the commodities faction--in fact, over the last 12 months, the food index has risen 2.1 percent and the energy index has increased 7.3 percent with the gasoline index up 13.4 percent—yet the annualized inflation rate for all items including food and energy, is rising at a rate of about 1.6%cent.
So how do we interpret the data above in light of the arguments from the various inflation/non-inflation camps? First we note that while prices have indeed risen to business, they have not shown to have risen as greatly to consumers, lending support to the fact that companies are currently unable to pass on price increases. There may be a time-lag effect operating here, however, the persistently high level of unemployment may also well be a contributor. With current capacity utilization levels historically low and unemployment high, we have a way to go before that ability to pass on prices emerges and inflation ignites. That does not bode well for corporate margins, by the way, but that’s a story for another Ramblings.
Secondly, there seems to indeed be a commodities price factor in the rise we are seeing in costs at the wholesale level but those commodity price rises don’t seem to be driving consumer inflation to the same degree. Part of this, again, may be the inability of manufacturers to pass on price increases--Q4 earnings reports from the likes of P&G, Kellogg, Clorox and General Mills suggest that may be the case right now-- but part is also reflective of a change the consumers’ model consumption basket used to calculate CPI—simply put, energy, food and other commodities are less of a component in the basket used to measure inflation than they were 20 years ago. In fact, housing is almost 40% of the CPI index weightings and the continued oversupply in that segment of the economy portends to hold down reported inflation for a long time to come.
Finally, as we have seen throughout the recession and recovery, manufacturing productivity has risen dramatically—something no camp can seem to fit into their models. This means that companies are now, and most likely will be into the future, able to produce the same amount of output with fewer workers and fewer raw materials. This argues against any short-term Phillips Curve bump in inflation—unless 9% becomes the new natural rate of inflation, which we doubt (and pray for to be otherwise)—and suggests that companies will continue to be more efficient in their raw material per unit consumption. Continuing productivity enhancements are the one glitch in all the above camps’ inflation models.
In summary, in our opinion, all three theories of inflation are at work here and for the moment, are counterbalancing one another, keeping inflation low. We may yet see the inflation the easy money and commodity camps suggest, but the Phillips Curve folks, combined with a fair amount of slack in manufacturing and productivity enhancements, are keeping it in check for now and into the foreseeable future. Interestingly, from the recent Fed minutes, that also appears to be what the Federal Reserve is seeing…so for now we’ll take a page out of Investing 101 and not fight the Fed.
Since the Fed embarked on its second round of quantitative easing back in mid-November, economists, portfolio managers and politicians alike have appeared on TV to argue whether the program is an effective stimulant to the US economy in the long-run and whether the end-result would be much higher levels of inflation in the short-term. Here we examine the inflation argument.
One faction of the inflation camp argues that loose monetary policy is a recipe for runaway price rises as it raises the demand for consumption and capital investment, often in projects that would be uneconomical under a normal monetary regime—the old “demand-pull” cause of inflation from the text books. An opposition group, the “don’t worry just yet” camp, however, have argued in favor of the classic Phillips Curve theory, that inflation is directly related to the level of employment in an economy and that there is a historical inverse relationship between the rate of unemployment and the rate of inflation. This “cost-push” textbook inflation, they believe, is unrelated to monetary policy and is far off given the persistently high levels of U3 (the official unemployment rate, hovering around 9%) and, especially, U6 (total unemployed, plus all persons marginally attached to the labor force, plus total employed part time for economic reasons, as a percent of the civilian labor force plus all persons marginally attached to the labor force—currently 16.1%) labor underutilization. Yet a third group, in the inflation camp, the “competition for resources” faction, has postulated that surging commodity prices (in part related to the weak dollar from QE2 but also directly tied to insatiable demand from fast-growing emerging markets) will export inflation to our shores regardless of easy money or tight labor. In this scenario, monetary policy is somewhat responsible for the level of prices as it drives up demand for commodities, thus raising the costs of raw materials to producers and food, energy and other necessities to consumers, but the rest of the world is the real culprit behind inflation, rates and money supply independent.
Whom should we believe in this heated and ongoing debate? To begin, there is some basis to support the inflationary camp’s position that loose money will ultimately result in inflation. The rise in the money supply, combined with no change in the output of goods and services, can create a situation where there is an elastic and excess supply of money chasing a relatively inelastic supply of “wants.” The result is, at the margin, the prices of those “wants” will increase, driving inflation. Where this theory falls short is that output, in the longer run, is fairly elastic as companies can increase capacity, explore for more natural resources, etc. Money alone doesn’t drive inflation, it is the consumers’ demand for that money and the things it can buy paired off against the producers’ ability to supply that demand. Currently, capacity utilization in the US is around 76%, about 10 percentage points below the normal rate of an economy at full output, and has slightly contracted in the last few months. Over the years, both the level of capacity utilization and the rate of change in capacity utilization have been good predictors of future inflation. Right now, neither indicator is pointing in the right direction, suggesting that even though demand for consumption and investment may be rising there is still sufficient slack in production capacity and the interest to increase it to keep inflation at bay for the time being.
As for the Phillips Curve crowd, there is evidence that employment levels can manipulate inflation in the short run. In the US services account for almost 80% of GDP, when Federal, state and local governments are included. As a result, labor costs are nearly 70% of total input prices to the economy. Any uptick in demand for labor, therefore, would seem likely to produce much higher costs to business and, thus, inflation. The Curve predicts an upward “death spiral” as lower unemployment produces a lower supply of workers and the higher wages they are able to demand further increases want of goods and services, thus causing companies to need to expand capacity and employment further. The dynamics of the Phillips Curve are complex and there has been much debate on its efficacy in predicting inflation over the long run, at which it has not done well. Many have argued that we need to get below a “natural rate of unemployment” (one that includes those perpetually in search of different employment or who just don’t want to work) before the demand for labor requires companies bid up the price to attract employees. Still others have argued that, over the long run, workers price their compensation to exactly match the rate of inflation, eliminating the upward “death spiral” the Curve prophesizes. The “stagflation” of the 70’s attests to the limitations of the Phillips Curve.
Finally, the commodity price theory has some basis but a number of drawbacks. As we mentioned, the stagflation of the 70s is an example where inflation was imported in the form of higher oil prices from OPEC while the economy sat with relatively high levels of unemployment. There is nothing to suggest that scenario cannot happen again, given the current turmoil in the Mideast, however, the 70’s OPEC embargo was an exogenous, manipulation of supply which turned out to be temporary. The world is a much different place in the current decade and though we have not reduced our addiction to imported oil, we have a much more flexible and diversified economy in which substitution can mitigate rising commodities prices (we’re already seeing such examples as aluminum replacing copper as those prices surge and abundant solar, nat gas and coal replacing more expensive oil). In addition, as we mentioned, services drive this economy, not manufacturing; raw materials comprise only about 5% of input costs. Inflation is an economic condition in which all prices rise, not just some. So we have a long way to go before the commodity alarmists’ dire predictions become of concern.
The ultimate question in predicting inflation is whether manufacturers will be able to pass the higher costs they incur (from whatever source) on to consumers. On Wednesday the Labor Department released the core producer price index, which excludes food and energy costs. It increased 0.5 percent in January, the biggest advance since October of 2008. Economists had expected a 0.2 percent gain. Most of the rise, however, reflected a jump in drug prices, which accounted for 40 percent of the increase and probably reflected a one-time price hike ahead of the implementation of Obamacare. The overall, non-core number, reinstating food and energy prices, rose a more hefty 0.8 percent, lending credence to the commodities inflation argument. This advance followed increases of 0.9 percent in December and 0.7 percent in November and marks the seventh straight rise in prices. These numbers represent costs to manufacturers. As we said, the ability to pass them on to consumers will ultimately determine whether we get inflation. On Thursday the BLS released the Consumer Price Index. The CPI increased 0.4 percent in January on a seasonally adjusted basis, half the level of the PPI. Moreover, increases in indexes for energy, commodities and for food accounted for over two thirds of the all items increase giving further support to the commodities faction--in fact, over the last 12 months, the food index has risen 2.1 percent and the energy index has increased 7.3 percent with the gasoline index up 13.4 percent—yet the annualized inflation rate for all items including food and energy, is rising at a rate of about 1.6%cent.
So how do we interpret the data above in light of the arguments from the various inflation/non-inflation camps? First we note that while prices have indeed risen to business, they have not shown to have risen as greatly to consumers, lending support to the fact that companies are currently unable to pass on price increases. There may be a time-lag effect operating here, however, the persistently high level of unemployment may also well be a contributor. With current capacity utilization levels historically low and unemployment high, we have a way to go before that ability to pass on prices emerges and inflation ignites. That does not bode well for corporate margins, by the way, but that’s a story for another Ramblings.
Secondly, there seems to indeed be a commodities price factor in the rise we are seeing in costs at the wholesale level but those commodity price rises don’t seem to be driving consumer inflation to the same degree. Part of this, again, may be the inability of manufacturers to pass on price increases--Q4 earnings reports from the likes of P&G, Kellogg, Clorox and General Mills suggest that may be the case right now-- but part is also reflective of a change the consumers’ model consumption basket used to calculate CPI—simply put, energy, food and other commodities are less of a component in the basket used to measure inflation than they were 20 years ago. In fact, housing is almost 40% of the CPI index weightings and the continued oversupply in that segment of the economy portends to hold down reported inflation for a long time to come.
Finally, as we have seen throughout the recession and recovery, manufacturing productivity has risen dramatically—something no camp can seem to fit into their models. This means that companies are now, and most likely will be into the future, able to produce the same amount of output with fewer workers and fewer raw materials. This argues against any short-term Phillips Curve bump in inflation—unless 9% becomes the new natural rate of inflation, which we doubt (and pray for to be otherwise)—and suggests that companies will continue to be more efficient in their raw material per unit consumption. Continuing productivity enhancements are the one glitch in all the above camps’ inflation models.
In summary, in our opinion, all three theories of inflation are at work here and for the moment, are counterbalancing one another, keeping inflation low. We may yet see the inflation the easy money and commodity camps suggest, but the Phillips Curve folks, combined with a fair amount of slack in manufacturing and productivity enhancements, are keeping it in check for now and into the foreseeable future. Interestingly, from the recent Fed minutes, that also appears to be what the Federal Reserve is seeing…so for now we’ll take a page out of Investing 101 and not fight the Fed.
Monday, February 7, 2011
Ramblings of a Portfolio Manager
So Has The Retail Investor Finally Thrown In the Towel?
As the old saying goes on Wall Street, equity markets tend to top out when the so-called “dumb money” (smug Wall Street jargon for the individual investor) finally realizes that stock prices are rising and dives in. The theory goes that individuals are the last to be informed that the economy and earnings are improving, thereby making the investment decision after all the good news has already been discounted by the markets—coming very late to the party, so to speak. Typically this adage is paired with something about the level of the Dow being published on the cover of Time Magazine or another similar pop-culture publication.
The theory, as we said, is a smug, insiders’ view of the markets and one that is most likely based on ancient foundations, given that the world is now “wired” with the average investor having as much access to financial and economic data as the pros on Wall Street. That’s not to say that the theory doesn’t still hold—only that its underpinnings may have changed. The last three years in the equity markets have probably done quite a bit to reinforce the foundations of this maxim with the financial crisis, huge market volatility, flash crashes and hedge fund fraud all making headlines impactful enough to scare even the professional investor into the mattress as a safe haven. So for the individual investor to begin to put his or her toe back into the equity market waters, there is a huge psychological ocean ahead to cross. And, like anyone facing a long, arduous swim, there has to be preparation—both psychological and structural—and that takes time. Thus, indeed, the individual investor may still be the last large pool of investment funds to commit money to these markets this time around.
With earnings coming in better than expected for the 10th quarter in a row and US equity markets seemingly shrugging off bad news from abroad (i.e. the good news is discounted yet the bad is being ignored) our investing sixth sense tells us that there are cash flows supporting stock prices that either need to or are desperate to be invested. That in mind, we thought we would revisit the ICI Weekly Money Flow tables to see if we can find anything unusual going on.
Estimated Flows to Long-Term Mutual Funds Millions of dollars (courtesy of ICI)
As one can easily see, funds’ flows into the US equity markets (a proxy for the individual investor) turned solidly positive in mid-January. This, while cash flows into foreign equity funds appear to have topped out and begun a decline. Where is the money coming from? At first glance, it is obvious that the outflow from municipal bonds appears to continue, with investors fearing defaults by state and local issuers thanks to dire warnings from the likes of Meredith Whitney. But that doesn’t explain everything. Have a look at the chart below, also courtesy of ICI.
Assets of Money Market Mutual Funds Billions of dollars (courtesy of ICI)
This chart describes what is going on in the money market and Treasury markets over the last few weeks. There is a slow, but noticeable, outflow from the so-called “safety” of short-term and government-backed fixed income securities that, combined with the outflow from munis, can explain whence comes the funds to invest in US equities.
Now, all this data can be very volatile and subject to the psychology of the markets of the moment but it does show a definite trend out of fixed income and into US equities. As talk of inflation in this country ramps up with every strong economic report, we would expect bond prices to make further declines, accelerating this trend. And while the funds flow into foreign equities continues to be positive, that is also in decline and with continued rate hikes in China and now India and perhaps Australia, along with more turmoil in the middle east splashing across the TV screen, we can expect this trend to hasten as well. Combining foreign equities and foreign bonds with US fixed income investments makes for a heckuva lot of money that can be freed up to flow into US equity markets, the one remaining perceived safe haven.
What does this all mean? Well, we hate to agree with the economists but many did say at the end of last year that 2011 may be the year for US equity markets. From our work, with very few other places to earn a “safe” return around the globe, the economists may have gotten it right this time.
As the old saying goes on Wall Street, equity markets tend to top out when the so-called “dumb money” (smug Wall Street jargon for the individual investor) finally realizes that stock prices are rising and dives in. The theory goes that individuals are the last to be informed that the economy and earnings are improving, thereby making the investment decision after all the good news has already been discounted by the markets—coming very late to the party, so to speak. Typically this adage is paired with something about the level of the Dow being published on the cover of Time Magazine or another similar pop-culture publication.
The theory, as we said, is a smug, insiders’ view of the markets and one that is most likely based on ancient foundations, given that the world is now “wired” with the average investor having as much access to financial and economic data as the pros on Wall Street. That’s not to say that the theory doesn’t still hold—only that its underpinnings may have changed. The last three years in the equity markets have probably done quite a bit to reinforce the foundations of this maxim with the financial crisis, huge market volatility, flash crashes and hedge fund fraud all making headlines impactful enough to scare even the professional investor into the mattress as a safe haven. So for the individual investor to begin to put his or her toe back into the equity market waters, there is a huge psychological ocean ahead to cross. And, like anyone facing a long, arduous swim, there has to be preparation—both psychological and structural—and that takes time. Thus, indeed, the individual investor may still be the last large pool of investment funds to commit money to these markets this time around.
With earnings coming in better than expected for the 10th quarter in a row and US equity markets seemingly shrugging off bad news from abroad (i.e. the good news is discounted yet the bad is being ignored) our investing sixth sense tells us that there are cash flows supporting stock prices that either need to or are desperate to be invested. That in mind, we thought we would revisit the ICI Weekly Money Flow tables to see if we can find anything unusual going on.
Estimated Flows to Long-Term Mutual Funds Millions of dollars (courtesy of ICI)
As one can easily see, funds’ flows into the US equity markets (a proxy for the individual investor) turned solidly positive in mid-January. This, while cash flows into foreign equity funds appear to have topped out and begun a decline. Where is the money coming from? At first glance, it is obvious that the outflow from municipal bonds appears to continue, with investors fearing defaults by state and local issuers thanks to dire warnings from the likes of Meredith Whitney. But that doesn’t explain everything. Have a look at the chart below, also courtesy of ICI.
Assets of Money Market Mutual Funds Billions of dollars (courtesy of ICI)
This chart describes what is going on in the money market and Treasury markets over the last few weeks. There is a slow, but noticeable, outflow from the so-called “safety” of short-term and government-backed fixed income securities that, combined with the outflow from munis, can explain whence comes the funds to invest in US equities.
Now, all this data can be very volatile and subject to the psychology of the markets of the moment but it does show a definite trend out of fixed income and into US equities. As talk of inflation in this country ramps up with every strong economic report, we would expect bond prices to make further declines, accelerating this trend. And while the funds flow into foreign equities continues to be positive, that is also in decline and with continued rate hikes in China and now India and perhaps Australia, along with more turmoil in the middle east splashing across the TV screen, we can expect this trend to hasten as well. Combining foreign equities and foreign bonds with US fixed income investments makes for a heckuva lot of money that can be freed up to flow into US equity markets, the one remaining perceived safe haven.
What does this all mean? Well, we hate to agree with the economists but many did say at the end of last year that 2011 may be the year for US equity markets. From our work, with very few other places to earn a “safe” return around the globe, the economists may have gotten it right this time.
Tuesday, February 1, 2011
Ramblings of a Portfolio Manager
Despite international concerns and related volatility late in the month the US Equity Markets largely turned in positive gains for January, 2011. Large cap stocks outperformed small caps, however, the Kettle Creek fund generated a positive return for the month as our low exposure to companies deriving revenues from foreign sources protected us from the continuing concerns in Europe while our overweight position in energy and shipping benefited the fund during the late-month turmoil in the Middle East.
January is best described as a month during which the same old fears regarding China and Europe continued to stalk the equity markets but went largely ignored, having been fully discounted over the prior quarter. With little to no new information being added into the equation the US equity markets climbed the proverbial wall of worry for most of the month, despite a brief, one-day sell-off at the end of the month on fears of unrest in the Middle East, sparked by riots in Egypt. Even these concerns over tensions in the Suez were short-lived as the market resumed its upward climb on the final day of the month.
In the US front, most economic data came through better than expected, with the exception of housing and employment, which continued to languish although many economists blamed the poor weather (principally in the Northeast) and were quick to remind investors that both are lagging indicators in an economic recovery. The one area of concern in the string of positive December data was new home sales which, released at the end of the month along with equally soft Case-Shiller home price data, were weak enough to ignite talk of a double dip in housing. Yet even that data couldn’t derail the rally, which pushed ahead despite the temporary weakness in housing and related stocks.
January also kicked off earnings season for most US companies and as the month began there was some concern that expectations had been elevated too high. Not only had analysts, encouraged by Q3 reports, QE2 impact and the positive developments on Capitol Hill, raised their forecasts significantly for Q4 earnings but traders and portfolio managers had further boosted those expectations through the whisper network. Along with the nearly straight run in US equities since the September lows, the record investor confidence it engendered, the high earnings expectations anxiety gave a great deal of material for the “correction” hand-wringers in the media. With the exception of two very bad days in the Russell 2000 and the one-day across the board sell-off on Middle East fears, however, the correction never came. With so many investors so worried about investor enthusiasm and the correction it was supposed to create, the sentiment essentially created a non-self fulfilling prophecy.
Our outlook on the US equity markets continues to be favorable for 2011 and into 2012. Late last year we were a little concerned about the recent bump in investor confidence, however, with so many other portfolio managers sharing the same concern, we essentially have a wall of worry ahead of us rather than a stock market bubble. In addition, with many emerging markets now in tightening mode and turmoil erupting in the Middle East—along with rising rates at home thanks to a strong economy—we believe that investment capital will begin to flow into US stocks, giving ample support for the theory that the US will be the place to invest for the next 18 months.
January is best described as a month during which the same old fears regarding China and Europe continued to stalk the equity markets but went largely ignored, having been fully discounted over the prior quarter. With little to no new information being added into the equation the US equity markets climbed the proverbial wall of worry for most of the month, despite a brief, one-day sell-off at the end of the month on fears of unrest in the Middle East, sparked by riots in Egypt. Even these concerns over tensions in the Suez were short-lived as the market resumed its upward climb on the final day of the month.
In the US front, most economic data came through better than expected, with the exception of housing and employment, which continued to languish although many economists blamed the poor weather (principally in the Northeast) and were quick to remind investors that both are lagging indicators in an economic recovery. The one area of concern in the string of positive December data was new home sales which, released at the end of the month along with equally soft Case-Shiller home price data, were weak enough to ignite talk of a double dip in housing. Yet even that data couldn’t derail the rally, which pushed ahead despite the temporary weakness in housing and related stocks.
January also kicked off earnings season for most US companies and as the month began there was some concern that expectations had been elevated too high. Not only had analysts, encouraged by Q3 reports, QE2 impact and the positive developments on Capitol Hill, raised their forecasts significantly for Q4 earnings but traders and portfolio managers had further boosted those expectations through the whisper network. Along with the nearly straight run in US equities since the September lows, the record investor confidence it engendered, the high earnings expectations anxiety gave a great deal of material for the “correction” hand-wringers in the media. With the exception of two very bad days in the Russell 2000 and the one-day across the board sell-off on Middle East fears, however, the correction never came. With so many investors so worried about investor enthusiasm and the correction it was supposed to create, the sentiment essentially created a non-self fulfilling prophecy.
Our outlook on the US equity markets continues to be favorable for 2011 and into 2012. Late last year we were a little concerned about the recent bump in investor confidence, however, with so many other portfolio managers sharing the same concern, we essentially have a wall of worry ahead of us rather than a stock market bubble. In addition, with many emerging markets now in tightening mode and turmoil erupting in the Middle East—along with rising rates at home thanks to a strong economy—we believe that investment capital will begin to flow into US stocks, giving ample support for the theory that the US will be the place to invest for the next 18 months.
Wednesday, January 12, 2011
Ramblings of a Portfolio Manager
Bullish Sentiment on us Equities is at a Recent High…and so is Market Pessimism Regarding the Bullish Sentiment on US Equities.
What a terrible time to invest. We hear it every day: the VIX is at a 2 year low, the put/call ratio is the lowest since January of 2006; US monthly stock market sentiment indices show the ratio of bulls to bears at 2:1, also a two year high; NASDAQ sentiment index is the highest since October of 2007; short interest fell 5.5% on both the NASDAQ and NYSE in December and, finally, the AAII Bull-Bear Spread is around 53%, also a two year high. All this points to investor sentiment at a near-term zenith and if you are a contrarian, as we tend to be, it’s about time to liquidate and run for the hills. The pragmatist in us, however, says hang on, not so fast.
A look at long-term mutual fund cash flows (courtesy of ICI), however, shows the movement back into US equity funds is only just beginning—a proxy for retail investor sentiment. In fact, net outflows from US equity funds stopped and turned positive for the first time only as recently as December 21st—and the net inflow number was tiny, dwarfed by flows into foreign equity funds by some 265:1. That trend continued through year-end with flows into US equity funds positive but tiny in comparison to those into foreign funds. For all the hand-wringing over rising rates, net cash flows into bond funds just went negative during the week of December 8th, continuing until the last week of the year when there was a big reversal, most likely due to asset allocation strategies pegged to the higher interest rate environment engendered by the recent rout in the Treasury market. Meanwhile, the flows out of Muni bonds continues amid fear of defaults by certain states. What to make of this? Well, if sentiment is so high on US equity markets, it has yet to be backed up by the money. And as Jerry Maguire would say…
A day doesn’t go by when we tune into one of the financial channels only to hear a half dozen market experts rehashing our sentiment analysis, using it as evidence that markets are overbought and due for a correction. We don’t necessarily disagree with them except for three important points: first, if everyone is so negative on everyone being so positive, doesn’t that sort of cancel things out? In our humble opinion, the answer is yes. Secondly, and we expect to be laughed at this given our view of technical analysis, the technicians look at all this bullishness with half see it as a good thing, half as bad. Synopses for several technical analyses:
The Pro:
At present, the short-term bullish outlook is supported by a strong technical backdrop, with the SPX advancing above the 1,250 area in mid-December. U.S. equity investors are more bullishly positioned than at any time in the last two years, figures show, following a sharp market rally since September. Investors currently have 10.8 times as many long positions as short positions -- bets on falling prices -- in the United States, the highest since the ratio was calculated two years ago, according to the data. Things that support this positive outlook:
1. Accelerating stock buybacks
2. Accelerating M&A activity
3. An extension of the capital gains and dividend tax cuts originally set to expire in 2011
4. The third year of a presidential term is historically bullish
5. An accommodative Fed
The Con:
We are seeing optimism enter the market recently, which means we may be vulnerable to a short-term pullback. For example:
1. Equity call buying relative to put buying on the Chicago Board Options Exchange and International Securities Exchange is at an extreme.
2. The CBOE Market Volatility Index (VIX) is now trading at a level that is twice SPX historical volatility. During the past two years, when the VIX is trading at such a high premium to SPX historical volatility, a mild to large pullback soon followed. The last time this indicator signaled was early November, ahead of a 3.8% retreat in the SPX.
3. For the first time since late April, domestic stock mutual funds experienced net inflows last week. The inflows are minute relative to the enormous outflows during the past three years, but one has to wonder if this eight-month "extreme" in optimism might precede a pullback in stocks? After all, during the past 10 years, the month of January experienced a correction, or marked the start of a correction, in five of those years (2002, 2003, 2008, 2009 and 2010).
• The AAII Investor Sentiment Survey measures the percentage of individual investors who are bullish, bearish or neutral on stock market for the next six months. As the masses are usually on the wrong side of market movements, particularly at tops and bottoms, sentiment indicator serve a useful function as contrarian indicators.
• The bullish sentiment (55.9%) and bearish sentiment (18.3%) readings are at fairly extreme levels, as also seen from the bull-bear spread being quite a bit higher than the market peak of October 2007.
• Sentiment indicators are fairly blunt instruments from a timing point of view and can stay at high / low levels for extended periods. However, when companies are overvalued and technical indicators overbought, overbullish sentiment indicators complete a threesome of tools arguing quite strongly for a cautious approach to stock market investment.
Since we don’t cotton well to technical analysis, the fact that their jockey shorts are all in a knot as to how to read the current markets is a good thing to us. When they all agree is when we hit the buy or sell button.
Our third reason to give pause before bracing for the coming sell-off is the ICI data. Yes, money is flowing strongly into equities….but it’s NOT going into US equities! In fact, the recent big flows out of bonds (only after they have sunk in market value by close to 20%) has been redirected into Foreign equity funds. Guess what? India is now down 6% for the year with many of the smaller Asian/Southeast Asian markets dragged lower in tow. So there is definitely some validity to watching the cash flows as an indicator of the retail investor coming in during a market’s last legs. The problem is, it’s not our market they are top-ticking. Predictably, they are chasing the past returns in India and the “Tigers” (or so they used to be called). We like that—because as retail left bond funds after having been burned, so too soon they will leave foreign equity funds after being burned…and where will they have to turn? The US, of course. What else is left? And it will be just in time for all the better economic data, which has been hitting the wires lately.
After a big move on January 2nd, the US markets have tread water, mostly with a downward bias. This is contrary to our, and many other fundamental analysts’ beliefs, that we would see a very strong run through the middle of January followed by a sell-off, which would be a buying opportunity. We’re not sure the sell-off is coming—or if we haven’t already had it (a consolidation as the technicians would say). Perhaps January will be a reverse of what we expect—early weakness followed by a month-end rally. That would sure put a knot in the socks of the fundamental guys as well as the technicians. We’re not saying that there wont be pullbacks, just that it’s too pat to try to call them based on the calendar and that, if they come, they should be short and shallow and present a good buying opportunity. Let’s not forget that the markets are still awash in liquidity and that European weakness/Chinese, Indian Inflation headline risk is not only discounted in investor’s minds but is being addressed in part with China willing to backstop Spain and Japan willing to pitch in to support Portugal. What other headlines do the Euros have to throw at us? And are there not piles of cash lined up for the day when China says “done raising rates?” If this market sells off the catalyst will have to come from within—we’ve heard the China/India/Euro record before.
What a terrible time to invest. We hear it every day: the VIX is at a 2 year low, the put/call ratio is the lowest since January of 2006; US monthly stock market sentiment indices show the ratio of bulls to bears at 2:1, also a two year high; NASDAQ sentiment index is the highest since October of 2007; short interest fell 5.5% on both the NASDAQ and NYSE in December and, finally, the AAII Bull-Bear Spread is around 53%, also a two year high. All this points to investor sentiment at a near-term zenith and if you are a contrarian, as we tend to be, it’s about time to liquidate and run for the hills. The pragmatist in us, however, says hang on, not so fast.
A look at long-term mutual fund cash flows (courtesy of ICI), however, shows the movement back into US equity funds is only just beginning—a proxy for retail investor sentiment. In fact, net outflows from US equity funds stopped and turned positive for the first time only as recently as December 21st—and the net inflow number was tiny, dwarfed by flows into foreign equity funds by some 265:1. That trend continued through year-end with flows into US equity funds positive but tiny in comparison to those into foreign funds. For all the hand-wringing over rising rates, net cash flows into bond funds just went negative during the week of December 8th, continuing until the last week of the year when there was a big reversal, most likely due to asset allocation strategies pegged to the higher interest rate environment engendered by the recent rout in the Treasury market. Meanwhile, the flows out of Muni bonds continues amid fear of defaults by certain states. What to make of this? Well, if sentiment is so high on US equity markets, it has yet to be backed up by the money. And as Jerry Maguire would say…
A day doesn’t go by when we tune into one of the financial channels only to hear a half dozen market experts rehashing our sentiment analysis, using it as evidence that markets are overbought and due for a correction. We don’t necessarily disagree with them except for three important points: first, if everyone is so negative on everyone being so positive, doesn’t that sort of cancel things out? In our humble opinion, the answer is yes. Secondly, and we expect to be laughed at this given our view of technical analysis, the technicians look at all this bullishness with half see it as a good thing, half as bad. Synopses for several technical analyses:
The Pro:
At present, the short-term bullish outlook is supported by a strong technical backdrop, with the SPX advancing above the 1,250 area in mid-December. U.S. equity investors are more bullishly positioned than at any time in the last two years, figures show, following a sharp market rally since September. Investors currently have 10.8 times as many long positions as short positions -- bets on falling prices -- in the United States, the highest since the ratio was calculated two years ago, according to the data. Things that support this positive outlook:
1. Accelerating stock buybacks
2. Accelerating M&A activity
3. An extension of the capital gains and dividend tax cuts originally set to expire in 2011
4. The third year of a presidential term is historically bullish
5. An accommodative Fed
The Con:
We are seeing optimism enter the market recently, which means we may be vulnerable to a short-term pullback. For example:
1. Equity call buying relative to put buying on the Chicago Board Options Exchange and International Securities Exchange is at an extreme.
2. The CBOE Market Volatility Index (VIX) is now trading at a level that is twice SPX historical volatility. During the past two years, when the VIX is trading at such a high premium to SPX historical volatility, a mild to large pullback soon followed. The last time this indicator signaled was early November, ahead of a 3.8% retreat in the SPX.
3. For the first time since late April, domestic stock mutual funds experienced net inflows last week. The inflows are minute relative to the enormous outflows during the past three years, but one has to wonder if this eight-month "extreme" in optimism might precede a pullback in stocks? After all, during the past 10 years, the month of January experienced a correction, or marked the start of a correction, in five of those years (2002, 2003, 2008, 2009 and 2010).
• The AAII Investor Sentiment Survey measures the percentage of individual investors who are bullish, bearish or neutral on stock market for the next six months. As the masses are usually on the wrong side of market movements, particularly at tops and bottoms, sentiment indicator serve a useful function as contrarian indicators.
• The bullish sentiment (55.9%) and bearish sentiment (18.3%) readings are at fairly extreme levels, as also seen from the bull-bear spread being quite a bit higher than the market peak of October 2007.
• Sentiment indicators are fairly blunt instruments from a timing point of view and can stay at high / low levels for extended periods. However, when companies are overvalued and technical indicators overbought, overbullish sentiment indicators complete a threesome of tools arguing quite strongly for a cautious approach to stock market investment.
Since we don’t cotton well to technical analysis, the fact that their jockey shorts are all in a knot as to how to read the current markets is a good thing to us. When they all agree is when we hit the buy or sell button.
Our third reason to give pause before bracing for the coming sell-off is the ICI data. Yes, money is flowing strongly into equities….but it’s NOT going into US equities! In fact, the recent big flows out of bonds (only after they have sunk in market value by close to 20%) has been redirected into Foreign equity funds. Guess what? India is now down 6% for the year with many of the smaller Asian/Southeast Asian markets dragged lower in tow. So there is definitely some validity to watching the cash flows as an indicator of the retail investor coming in during a market’s last legs. The problem is, it’s not our market they are top-ticking. Predictably, they are chasing the past returns in India and the “Tigers” (or so they used to be called). We like that—because as retail left bond funds after having been burned, so too soon they will leave foreign equity funds after being burned…and where will they have to turn? The US, of course. What else is left? And it will be just in time for all the better economic data, which has been hitting the wires lately.
After a big move on January 2nd, the US markets have tread water, mostly with a downward bias. This is contrary to our, and many other fundamental analysts’ beliefs, that we would see a very strong run through the middle of January followed by a sell-off, which would be a buying opportunity. We’re not sure the sell-off is coming—or if we haven’t already had it (a consolidation as the technicians would say). Perhaps January will be a reverse of what we expect—early weakness followed by a month-end rally. That would sure put a knot in the socks of the fundamental guys as well as the technicians. We’re not saying that there wont be pullbacks, just that it’s too pat to try to call them based on the calendar and that, if they come, they should be short and shallow and present a good buying opportunity. Let’s not forget that the markets are still awash in liquidity and that European weakness/Chinese, Indian Inflation headline risk is not only discounted in investor’s minds but is being addressed in part with China willing to backstop Spain and Japan willing to pitch in to support Portugal. What other headlines do the Euros have to throw at us? And are there not piles of cash lined up for the day when China says “done raising rates?” If this market sells off the catalyst will have to come from within—we’ve heard the China/India/Euro record before.
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