Slowdown, But No Double Dip, From Bob Doll, vice chairman and chief equity strategist for fundamental equities, BlackRock
US stocks are now up almost 10% from their lows in early July. Equity prices have been helped in recent weeks by continued strong corporate earnings. Results for the second quarter continue to come in at a rapid pace, and the current quarter has been one of the strongest in recent years, with close to 75% of companies so far having exceeded expectations. Analyst forecasts for the remainder of 2010 have been moving up as well, although expectations for 2011 have fallen slightly (likely because they were too strong to begin with).
On the economic front, the most important data that came in last week was the July employment report. The headline numbers were disappointing, as the United States shed jobs last month, largely as a result of the loss of temporary census workers. Additionally, private sector payrolls advanced by a less-than-expected 71,000 jobs. The unemployment rate remained steady at 9.5%. There were, however, some bright spots in the data. Hours worked and average hourly earnings both advanced, which augers well for the future. On balance, the report had something for both the bears and the bulls.
Other recent economic data shows that the personal savings rate has been climbing over the past couple of years. Interest expenses as a percentage of income have fallen by nearly 2% over the past two years as consumers have been working to save more. Although overall debt levels remain high, this data points to a positive trend. Also in the news last week were some statements made by Treasury Secretary Timothy Geithner, who indicated that the Obama Administration would like to see tax rates on capital gains and dividends move to 20%. As we approach the end of the year (when the 2003 tax cuts are set to expire), we expect to see much more debate over the direction of tax policy.
Overall US and global economic statistics continue to show that the pace of economic growth has trailed off in recent months. Both the US and Chinese Purchasing Managers’ Indexes for July, for example, indicated that there has been a loss of economic momentum. Nevertheless, recent market reactions have shown that many investors have shrugged off the recent weak data, suggesting that most are coming to believe the recovery will continue.
In addition to improving equity markets, industrial commodity prices have advanced by almost 15% since early June. It is difficult for us to reconcile rising commodity prices with a view that the Chinese economy is collapsing or that the United States and other developed markets are heading for a double dip recession. From our perspective, the recent soft patch of economic data is just that — a slowdown in the pace of recovery and not an indication that the economy is sliding back into recession.
Bullish Signals, From Charles Biderman, CEO, TrimTabs
While our macroeconomic indicators suggest the economy is sputtering, our investment demand indicators remain bullish. The TrimTabs Demand Index (TTDI), which uses the historical relationships between equity prices and 21 flow and sentiment variables for market timing purposes, closed at 82.9 on Thursday, August 5 (readings above 50 are bullish). The index is less than 10 points below the interim high of 91.8 on April 5.
The TTDI is elevated in large part because the level of retail money market fund assets is historically low, and equity ETFs have been posting heavy outflows (which is bullish from a contrarian perspective).
The S&P 500 has soared 9.7% from its July 2 low, but leveraged ETF investors (many of whom are day traders) continue to bet on lower stock prices. Leveraged long U.S. equity ETFs redeemed 2.2% of assets in the past week and 8.6% of assets in the past two weeks. Meanwhile, leveraged short U.S. equity ETFs posted inflows of 0.3% of assets in the past week and 4.2% of assets in the past two weeks.
Our research shows that leveraged equity ETF flows are an excellent contrary leading indicator. That day traders are abandoning longs as well as adding shorts suggests the S&P 500 could continue to grind higher.
Deflation? Not, From Jeffrey D. Saut, chief investment strategist, Raymond James
Here is another perspective on the inflation/deflation debate. Since June 1981, when Paul Volcker started to lower interest rates from 20% as high inflation rates started to fall, the absolute level of CPI rose 142% to the high in July '08 (90.5 to 217). Deflation is defined as a decrease in the general price level of goods and services; but, to quantify the current fall in prices, the CPI has fallen just 1% from its all time high. This tiny price move, notwithstanding we are still near an all time high in the daily cost of living, has led to talk that the Fed needs to do more to avoid deflation at all costs and thus create inflation via more quantitative easing . An example, oil goes from $50 to $85 in one year and the next year falls 1% to $84.15 and we’re told there is deflation and deflation is bad.
Deflation has always been a “bad bet,” except for the 1930s. Currently, however, deflationary concerns are swirling on the “street of dreams;” and, I don’t believe them. I think the present-day policies will actually prove inflationary. Given the current economic policies, the nascent economic recovery is likely to be slow, but with no double dip. And, that what’s happening as the recent economic reports have softened, punctuated by last Friday’s ugly employment numbers. Nevertheless, the economy will recover with inflation (not deflation) likely to follow. Accordingly, I think the equity markets should grudgingly work their way higher, even though I remain cautiously positioned. Given that cautionary stance, I favor the strategy of buying high quality, dividend paying stocks combined with special situation income funds.
Deconstructing the Agg, from Janus Investment Insights
One of the fallouts from the financial crisis and the subsequent government intervention in the credit and mortgage markets has been the convergence of government agency and agency mortgage spreads. Government agency debt and agency mortgages have had similar yields to U.S. Treasuries since late 2008 when the U.S. government placed Fannie Mae and Freddie Mac into a conservatorship. We believe this event resulted in a structural change within fixed income that has essentially reduced the number of sectors from four to two: corporate credit and government. We believe this structural change will persist for several years and that investors may want to revisit their approach to fixed income investing given the implications of this change on one of the indices most commonly used by passive investors, the Barclays Capital U.S. Aggregate Bond Index (“the Agg”). The low interest rate environment and the Agg’s longer duration make the index more sensitive to interest rate movements.
At the end of May 2010, the Agg was composed of roughly 35% agency mortgages, 31% U.S. Treasuries, 23% corporate credit, 8% government agencies and 3% asset-backed and commercial mortgage-backed securities. For much of the 1990s, agency mortgages had a smaller weighting in the Agg than they do today, averaging less than 30% during the period. Agency mortgages gradually increased to make up a larger portion of the index, peaking near 40% in late 2008 before falling back to 35% amid the financial crisis. Relatively low coupons coupled with slow prepayments and a low interest-rate environment have extended the duration of these securities and the Agg.
Looking ahead, we think passive investment strategies tied to the Agg are likely to underperform active strategies due to their large weighting in government securities and the low interest rate environment. Active management, particularly security selection within the corporate credit sector, may be the single most important factor in generating risk-adjusted outperformance in fixed income.
Interest Rate Headwinds, From Stephen J. Huxley, Ph.D., chief investment strategist, Asset Dedication
Market turbulence following the financial crisis in 2008 has led to unprecedented flows into fixed income investments, especially pooled fixed-income products like bond funds and bond ETFs. The current low rate environment highlights the risk that pooled bond investments face when rates inevitably begin to rise. All fixed income investments have benefited from a tailwind of historical proportions during the past three decades. It’s my concern that most investors don’t remember, or have never experienced fixed income investing when rates are rising.
Most fixed income investments performed extremely well over the past 29 years because of the inexorable decline in yields after hitting their highs in the early 1980s. Over this span, yields on the 10-year Treasury averaged 6.2%. But total returns (including appreciation) have averaged 9.7%—more than 50% higher than yields alone. In other words, falling yields provided a wonderful tailwind. The industry’s trend toward using pooled investments may end up causing unintended but disastrous results the next time we see sustained rises in interest rates.
So how strong will the rising-rate headwinds be? In the 31 years before 1981, yields on the 10-year bond rose nearly every year, starting at 2.1% in 1950 and peaking at 13.9% in 1981. Yields averaged 5.6%. Total return, however, averaged only 4.2% with frequent negative years. Without the ability to lock in yields by immunizing individual holdings, pooled portfolios again will systematically see total return erode as NAV flattens and falls.
Going forward, portfolios of individual bonds are positioned to deliver better results since individual bonds can both enjoy both appreciation and coupon interest when rates are falling and lock in coupons as a floor when rates are rising. The good news is that many giants in the industry have started to take steps. Among the primary custodians for advisors’ assets, both Schwab Advisor Services and Fidelity Institutional Wealth Services have bolstered the depth and breadth of their individual bond capabilities (both directly and through sub-advised products) and ramped up their communications to advisors on this topic. Many of the largest managers of pooled fixed-income assets seem to be waving a warning flag to advisors and investors, leading them to other asset classes or more direct investments where appropriate.
Tuesday, Aug. 10:
Fed Funds Rate Announcement; Small Business Optimism Index; Retail Sales (weekly); Productivity and Labor Costs (Q2), Wholesale Trade (June)
Wednesday, Aug. 11:
Mortgage Applications (weekly); International Trade (June);
Thursday, Aug. 12:
Jobless Claims (weekly); Import/Export Price Index (July)
Friday, Aug. 13:
U. Michigan Consumer Sentiment Index (August); Consumer Price Index (July); Retail Sales (July); Business Inventories (June)