Investors are becoming as bullish as they were in October, 2007, a reason for caution, says Raymond James, which notes that its volatility index is at the levels last seen in April before a 17% correction. Capital markets stocks are attractive, and so may be energy and metals. The move toward international financial regulatory reform may be stalled.
Jeffrey D. Saut, Raymond James Investment Strategy
The White Hurricane
“Unseasonably mild and clearing” was the weather forecast going into the Ides of March back in the year of 1888. And it was true, as temperatures hovered in the 40s and 50s along the East Coast. However, torrential rains began falling, and on March 12, the rain changed to heavy snow, temperatures plunged, and sustained winds of more than fifty miles per hour blew. The “Great White Hurricane” had begun! In the next 36 hours, some 50 inches of snow would blanket New York City, and the winds would whip that snow into 40- to 50-foot snowdrifts. Telegraph and telephone lines were snapped, fire stations were immobilized, New Yorkers could not get out of their homes, 200 ships were blown aground, and 400 people would die before the storm was over. The resulting transportation crisis led to the construction of New York’s subway system.
I revisit The Great Blizzard of 1888 this morning not just because of last Monday’s Manhattan blizzard but because there are pundits increasingly calling for an “unseasonably mild and clearing” outlook for the stock market. While I too think any correction will likely be for buying, I am becoming more cautious now that we are in January, worried about a repeat of January 2009. Recall what happened last year; I was cautious coming into the new year while the “crowd” was waxing bullishly. And just to make me look foolish, the S&P 500 (SPX/1257.64) rallied 3.2% from 2009’s year end to a short-term peak on January 19th of 1150.23. Accordingly, the cry went out: “So goes the first week of the new year, so goes the month, and so goes the year.” However, from that January peak, the SPX fell over 9% into its February 5th low of 1044.50. Subsequently, I wrote: “John Mauldin and I discussed the ‘state of the state’ as we cruised around the Gulf of Mexico in my boat yesterday while wearing our Minyanville.com hats. John is more worried about deflation while I remain worried about inflation.
This morning, however, the equity markets don’t seem to be worried about either as gold and crude oil are relatively flat and the pre-opening S&P 500 futures are better by some 4 points. I think the trading lows are ‘in’ and have tilted accounts accordingly.”
We rode “the bull” from February 2010 until late March when most of my finger-to-wallet indicators counseled for caution. Once again, I looked foolish as the SPX rose another 4.2% into its April 26th intra-day high of 1220. From there, the SPX fell 17% into its July 1st low. As repeatedly stated in these missives, “All you had to do in 2010 to be a successful investor was to get two things right.” First, you had to avoid losing much money in the first six months of the year, and then, you had to stay constructive on stocks the second six months of the year. The point of this diatribe is that in this business you have to play the odds. When they are tipped heavily in your favor, you should “play” pretty hard. When they are not, you have to pull in your horns or run the risk of losing real money. As Charles Knott, eponymous captain of Knott Capital, opines, “[Investment] opportunities come again and again; your clients’ principal comes but once!”
Plainly, I agree with Charlie, and in the short-term, the odds are not tipped decidedly in investors’ favor, at least not by the metrics I use. Indeed, the Volatility Index (VIX/17.75) is down to “complacency levels” last seen in April right before the 17% correction.
Ditto, Investors Intelligence data shows advisory sentiment approaching the bullish extremes of October 2007. Meanwhile, stock market leadership is narrowing, internal momentum is waning, and every macro sector except Utilities is overbought. Additionally, correlations between various asset classes are decreasing, implying that investors are becoming increasingly selective. All of this suggests more caution is warranted as we enter the new year.
Speaking of the new year, this new year brings with it new rules. While taxpayers will continue to be required to report cost-basis information to the IRS, beginning January 1, 2011, under the Emergency Economic Stabilization Act of 2008, broker/dealers, banks, custodians, and transfer agents will also be required to report taxable cost-basis information to the IRS on securities covered under the new rules. The legislation will be phased in over the next three years beginning with equities acquired on, or after,
January 1, 2011. You should know that if investors wish to specify a particular tax lot to be sold or transferred, beginning January 1, 2011, this must be indicated prior to settlement date. Moreover, as of this date, cost basis accounting method adjustments cannot be accepted after settlement date. The new regulations can have a significant impact on investors’ tax situations as well as monetary penalties, and I encourage you to familiarize yourself with the new legislation.
With these thoughts in mind, I leave you with the following quip titled “Resolved; An Investor’s New Year’s Resolutions” by John Magee. To wit, resolved, that in the coming year:
• “I will not alienate my friends and antagonize my family by reminding the world on every possible occasion how right I was about the upturn – or downturn – in steels, motors, airlines, or whatever.
• When I buy a stock I will not mobilize all the good news to make it look pretty. I will try to consider both the favorable and unfavorable angles as impartially as I know how.
• I will not close out a stock position that is doing well by me for no other reason than that I have a profit. I will not cut short my gains in a good situation.
• I will not hang on to a stock that is persistently going against me. I will limit my loss and close out any position that seems to have gone really bad before I am in danger of serious trouble.
• I will not be swayed or panicked by news flashes, rumors, tips, or well-meant advice.
• I will not put all my eggs in one basket nor will I be swept off my feet to plunge into some unknown or low-priced stock on a purely emotional basis.
• I will not attempt to tell the market what a stock ought to be worth. I will try to understand what the market has to tell me about what people are willing to pay for it.
• I will never forget that I am not in the market primarily to prove – to my broker, my friends, my wife, etc. – that I am smarter than everybody else, but to protect and, if possible, to augment my capital.”
Those of you unfamiliar with John Magee should know that he was the author of Technical Analysis of Stock Trends, a book described as “the standard text for anyone interested in the construction and interpretation of charts; comprehensive, profusely illustrated, covering everything from alpha to omega; truly, a brilliant work!”
The call for this week: “History doesn’t repeat itself, but it does rhyme,” is a timeless quote from Mark Twain. Adhering to its meaning, I am worried that last January’s stock market pattern may be repeated this year. While markets can certainly do anything (read: can continue to travel higher), the odds are not tipped in investors’ favor in the short-term and I am cautious. As for fixed income, the recent “yield yelp” lifted the yield on the 10-year T’note from 2.37% to 3.57%; it currently resides at 3.31%. I expect interest rate spreads to compress in January, implying there could be some short-term opportunities in select fixed income vehicles.
Frederick Cannon, Keefe, Bruyette and Woods
2011 Outlook
More than two years after the financial crisis, we believe the U.S. financial services sector is poised to shift toward capital deployment from capital accumulation in 2011. Capital redeployment will focus on increased dividends, share repurchases, and mergers and acquisitions, in our view. Lending will remain constrained as the U.S. economy continues to increase savings and reduce debt. As a result, valuations will likely improve for those firms that are early to redeploy capital, such as the large brokers and banks that have repaid government investments, but will lag for those firms that will be required to raise additional capital or restructure due to government regulation.
Continued consumer deleveraging will likely result in slow growth in the U.S. in 2011. Our forecast is that U.S. gross domestic product (GDP) will grow slightly less than 2% next year and the unemployment rate will fall to 9.1% by year-end 2011. We do not expect debt-to-income levels to stabilize before year end, with continued high savings rates extending into 2012.
In our opinion, the Federal Reserve will maintain interest rates at a low level across the yield curve throughout 2011, stimulating increased bank reserves, but also increased risk taking. We believe that the Fed’s policies will begin to succeed by next spring, allowing increased capital markets activities and increased demand for troubled assets, and allowing financial firms to resolve remaining asset problems by year end.
In our view, the move toward global capital and regulatory standardization has stalled. Nations will become more inward focused when determining financial regulation and capital standards. For the U.S., this means that large financial institutions will increasingly be able to deploy capital at current levels and look for opportunities for global regulatory arbitrage. Overall, this should enhance the outlook for the return on equity (ROE) for the sector.
Capital markets will be the strongest area for growth in 2011, in our opinion, while bank loan balances will be the greatest area of weakness. The expansion of share values for Equity REITs, the best sector for share expansion thus far in 2010, will likely not be sustained. Regulatory pressures on the industry will remain high with the implementation of the Dodd-Frank bill. However, onerous implementation of regulations will be constrained as a result of recent changes in Congress.
David Konrad, Keefe, Bruyette and Woods
Banks.: Back to Business in 2011
Overall, we have a favorable bias toward universal banks given their diverse revenue mix as well as their potential growth opportunities in emerging markets. Given our expectations that the Fed is likely to hold down interest rates, we believe banks with exposure to capital markets have a better revenue outlook for 2011 than banks with greater reliance on spread income.
Looking into 2011, we believe the universal bank group is better positioned than many of its large-cap U.S. bank peers, given the more diverse revenue mix and exposure to capital markets. Given our expectations that the Fed is likely to hold down interest rates through further quantitative easing, we forecast that banks with meaningful exposure to capital markets will have a more promising revenue outlook for 2011 than banks with greater reliance on spread income.
In addition, operations in emerging markets including China and Brazil offer growth revenue prospects for several of the universal banks, especially relative to large-cap U.S. bank peers.
Relative valuations for the universal bank group appear attractive, in our view. The universal bank group is currently priced at 1.2x tangible book value (TBV) and 10.2x our 2012 earnings estimates, which is a discount to the BKX trading at 1.5x and 12.2x, respectively.
With continued clarity on Basel III expected and the results of the Federal Reserve’s Supervisory Assessments coming due in January, we believe that the strongest banks will soon get the green light to deploy capital to increase dividends and also to repurchase shares. Of the U.S. universal banks, we believe that only JPM and GS will be in a position to return capital to shareholders through dividend increases in 2011. We expect BAC, C, and MS to continue to build capital ratios at least through 2011.
J. Michael Martin, Financial Advantage
Profit from emerging nations’ skyrocketing demand for energy and metals by investing in North American and European mining and energy companies.
Because of the exploding requirements of developing countries, worldwide demand for hydrocarbons and metals will keep rising faster than supply. Their consumption of raw materials is growing even faster than their GDPs.
Investing in hard-asset companies lets investors harness the dynamism of emerging markets without getting exposed to their political and currency risks, he says.
Expanding output at existing mines is costly because remaining deposits are of lower quality. Exploring for new resources and opening up new mines and wells is a slow, investment-intensive process. All that points toward higher commodity prices.
“Quantitative easing” in the US and the eurozone will drive prices higher.
There’s no political will to cut spending or raise taxes. On both sides of the pond the only practical compromise seems to be to print money—and the extractive industries are in the best position to protect their real returns with price increases.
We take a four-pronged approach to investing in natural resources:
Oil, gas and coal. We favor companies that own energy reserves in politically stable countries. They include large US multinationals as was as well niche players like Canadian oil companies.
Copper and iron. Our metals stocks are international mining operations based in Canada and Europe, and one Brazilian company, his only direct investment in an emerging market.
Timber. Our firm’s portfolio includes the largest owner of US timberland.
Gold bullion. We trimmed gold back a bit in 2010, to 7 percent of his firm’s core portfolio, but believe it should still be in everyone’s portfolio. Gold is a currency that can’t be printed, accepted all over the world as a store of value and medium of exchange. As national debts pile up and confidence in paper money declines, gold goes up. It’s a long term play, not a trade.
Our firm currently has about 12 percent in energy, mining and gold bullion. We anticipate almost doubling the firm’s allocation to “hard assets” in 2011.
Despite our bullishness on the sector, we caution investors not to overdo it.
Money managers can scarcely resist the opportunity to play the seer, but mortals can’t know the future. The first rule of prudent investing always is: diversify.
Jason Pride, Glenmeade, Ahead to 2011 – Recovering Again
Leading indicators and business surveys continue to point upwards.
Initial claims have convincingly broken out of their range (under 400k jobless claims in latest report), suggesting monthly employment figures should be positive.
Bottom Line:
The economic recovery that started in 2009 has resumed and looks likely to continue in 2011.
US has chosen stimulus first, Europe has chosen austerity – markedly different paths.
The new US tax bill provides yet more stimulus, although only adding to the bigger issue.
The EU has agreed to a permanent bailout facility; markets still feel policymakers are behind the curve, however, and worries continue.
Bottom Line:
Ultimately, both areas are likely to implement both easy monetary/tight fiscal policies.
The U.S. needs to implement fiscal discipline, while Europe needs more support.
The U.S.’s stimulus-first plan likely to prove the more efficient and stable path.
Economic and Market Viewpoint:
The global economy, still recovering from the recession, looks ready to expand in 2011.
The global economy still faces multiple headwinds.
Momentum to reduce government spending is building.
U.S. politicians continue to kick the debt/deficit can down the road.
Developed market currencies are likely to remain under pressure.
Investment Themes:
Underweight low-yielding assets such as cash and Treasuries.
Shift portfolio allocations toward undervalued/attractive assets:
Undervalued Equities: U.S. quality growth and European Multinationals.
Fixed Income: municipals, high yield, global bonds.
Position to benefit from growth in the emerging market middle class.
Protection from devaluation: emerging market currencies and commodities.
Covered call strategy.
Invest to benefit from falling correlations: hedge funds and active managers.
Guy LeBas, Janney Scott
Each January, we produce a list of our Top Surprises—events which we believe have a reasonable hance of occurring, but which the markets are not pricing in—for the New Year. For 2010, six of our top ten surprises came to fruition, ranging from the probability that commercial real estate defaults would remain limited to the likelihood that the EU would step forward and bail out a peripheral member country (the latter surprise being a reality twice over). At this point, 2010 is in the history books, and the focus is turning to the coming year. On balance, economic growth should resume at a slow though positive pace and financial market conditions should avoid any of the distresses that plagued the final years of the last decade. We do see a range of unexpected risks emerging, though for the most part, these risks are less problematic than the ones present in recent years.
United States Macro
Home prices experience another 10% or greater nationwide decline in 2011, resulting in an extended construction industry slump and an increase in mortgage defaults.
High probability, moderate impact.
After two years of elevated unemployment, productivity gains slow, causing wages to become unstuck and drop, thereby triggering the early stages of a deflationary spiral.
Low probability, high impact.
The Federal Reserve, seeing an increasing risk of deflationary spiral, expands the QE2 asset purchase program to $1.0 trillion, creating greater political debate as to the Fed’s role.
Moderate probability, moderate impact.
Congressional spending cuts fail to live up to election hopes, leading to Treasury supply concerns and causing real yields to continue to rise despite constrained inflation outlook.
High probability, high impact.
Global Macro
A bailed-out Eurozone nation goes back to the trough for a second round of aid; Germany responds by demanding bondholders take haircuts as a condition of that additional aid. The Euro falls back past the $1.10 mark.
Moderate probability, high impact.
Talk of currency manipulation including from the Fed and QE2 triggers an international rhetoric war which leads to problematic capital controls and/or foreign investment taxation.
Low probability, high impact.
Corporate
Corporate re-leveraging transactions among investment grade rated firms boost the equity markets at the expense of credit quality by driving EPS higher even as P/E ratios decline on weaker quality of earnings.
High probability, moderate impact.
Falling home prices trigger an increase in ruthless mortgage foreclosures, causing 2007 – 2009 originated mortgages to default at a higher rate and impairing bank profitability through 2013.
High probability, moderate impact.
A government-involved Chinese company (non-financial such as Sinopec) looks to acquire a major US firm, generating debate about the risks and appropriateness of foreign ownership of US businesses.
Low probability, moderate impact.
Commodities
Coal prices soar to $100 per ton (+25%) on a sudden uptick in Chinese imports as the country’s power and steel needs pass the levels that can be covered with domestic coal.
High probability, low impact.
Agricultural commodities prices retreat by spring on a strong supply outlook led by grains, with the DJ-UBS Agriculture index falling back to the low 70s level (-20%).
Moderate probability, low impact.
