Bob Doll, Black Rock
Uncertainty levels remain high and investors are struggling with a myriad of economic issues. Because clarity levels and conviction are both low, investment sentiment and volatility swings have been magnified in recent weeks. From our perspective, we believe there are a number of issues that warrant concern, but we believe investors should look past the near-term risks and view the current weakness as a potential buying opportunity.
First, on the economic front, the US economy is faced with some significant structural headwinds that have made for a sluggish recovery. Despite the more negative tone of economic data over the past couple of months, we do not believe we are in the midst of anything more serious than a rough patch occurring in the middle of a sustained recovery. As such, we are optimistic that we will see a reacceleration in growth in the second half of 2011. Global industrial activity appears poised for a rebound, consumer spending levels have remained resilient, household savings rates have been climbing, banks continue to ease lending standards and corporate confidence levels remain high. The labor market experienced a downturn in May, but we believe the longer-term trend in jobs growth should remain positive. Overall, we think a pickup in economic growth in the second half of the year is likely and we are expecting to see gross domestic product growth of around 3% for the last six months of 2011.
An additional issue that has investors concerned is the current state of monetary policy. We have been commenting extensively on why the pending end of the Federal Reserve’s quantitative easing program (QE2) should essentially be a non-event for investors, but questions do remain about what the Fed’s next steps will be. Given the recent weakness in economic data, some investors are awaiting signals for the launch of QE3, but we think there is little likelihood of that occurring. Quantitative easing programs are (by definition) inflationary, and since inflation risks are rising, the Fed will be reluctant to add to inflationary pressures. Additionally, the political backdrop is not one in which further quantitative easing measures would be welcome. As a result, we believe there would have to be a clear risk of the United States re-entering a recessionary and deflationary spiral before the Fed would contemplate a QE3 program — an environment we do not believe is likely.
Outside of the United States, investors are again focusing on European debt issues, particularly the debt crisis in Greece. Policymakers are struggling to reach a long-term agreement that will resolve the crisis without risking further contagion. There has been some talk that a policy of deliberately engineering higher inflation levels could ease debt burdens, but we think that such an approach could have disastrous consequences.
Despite a widespread perception that higher inflation reduces public debt burdens, we believe that such an environment would increase net new borrowing costs, making it more expensive to finance deficits and refinance maturing debt. Looking ahead, we expect the European Union and the International Monetary Fund to continue to provide support for Greece. Ultimately, the best resolution would be a combination of sustained economic growth and fiscal austerity. Engineering such an environment is, of course, monumentally difficult, meaning that risks related to sovereign debt crises will not disappear any time soon.
For investors, there is certainly no shortage of things to worry about, an environment that has caused stocks to move in a corrective or sideways pattern for close to two months. We do expect investor anxiety and market volatility levels to remain elevated for the time being. At some point, we expect stock valuations will settle at a level where investors feel adequately compensated for the downside risks facing the market. We are retaining a constructive view toward the economy and the markets and we suspect such a valuation level is not too far away. As such, we continue to recommend that investors view the current period of weakness as an opportunity to take on additional risk.
Don Hays, Hays Advisory
Our Valuation Composite is telling us that the odds are huge that the stock market will be much higher in the next 4-5 years. It is most definitely a longer-term measure, but based on today’s level of valuation, it is saying that historically, this has meant the annual gains in the next 4-5 years should be 16%+.
Our Monetary Composite is perhaps the most dependable of all our composites. When it talks, smart investors listen…and act. It has been amazingly accurate at predicting bull and bear markets for the last 60 years, and perhaps even more amazing, it has been even more accurate at predicting markets in these last volatile 10 years. When it has been as bullish as it is now, it is saying that the next 18 months could (should) be up by 32%.
And now…finally we are seeing some dramatic improvement in our Psychology Composite. This is the one that had that strange period back in 2007-2008. If you remember, that was the time when the Fed had been tightening monetary conditions almost every month since June 2004. The zero carry trade coming out of Japan and the ¨Dshadow banking system¡¬ had taken over control of much of the leveraged economy, and the Fed couldn’t get the control it coveted. So ¨Ddisintermediation¡¬ occurred in 2007, and as Warren Buffet says, ¨DWhen the tide goes out (tough monetary conditions), the skinny dippers get exposed. This tight monetary system certainly exposed the leverage, and effectively killed the spirit of ¨Dinvestors and ¨Dconsumers/
To get back to Psychology, as the small investors and traders left the scene in 1996, the big derivative and highly leveraged traders were in sole control. So many of the traditional ¨Ddumb Psychology Indicators that were based on small public speculators simply lost their ability to measure ¨Ddumb sentiment. The more speculative, but uninformed public speculators, were nowhere to be found.
Okay, my opening statement—things I believe, but that I can’t prove to the nervous crowd. I believe those great Psychology Indicators of the past that failed to work in that 2006-2008 period are now coming back as valuable tools.
We believe that the distortion of the stock market in 2007-2008 was a very important message sent to the American people and the world, to get the massive leverage and derivatives and spending under control.
We believe that inflation was cured way back in1984, and that it will remain tame for many years—possibly decades.
We believe that bond yields will remain very low, running 2-3% above inflation and that today’s 30-Year T-Bond is now moving into the stable yield zone that it will stick to for many years to come. Bond volatility will dampen substantially.
We believe the major currencies are also going to reduce their volatility, but the emerging countries whose currencies were so weak in the wake of 1997’s collapse will gradually dig their way out of that 15-year hole. Hence, their deflated price parity will gradually be reduced versus the U.S.—making U.S. manufacturing more attractive.
We believe the next few years will produce a very sustainable bull market, and actually the volatility will be much less.
We believe the price-earnings ratio of the S&P 500 based on the next 12-month forward earnings will gradually increase in the next four years from today’s level of 12.5 to 16, and as earnings continue to improve, the S&P 500 will produce gains of 12-15%.
We believe in our Asset Allocation Matrix, and it says that you should have maximum exposure in your investment account to equities. Investing is not trading, and nobody can predict that the next few weeks will not have more volatility, but the odds are tremendously on the side of very strong gains in stocks over the next 6-30 months.
Jeffrey D. Saut, Raymond James
Down the Rabbit Hole
Alice in Wonderland: Sir, would you tell me, please, which way I ought to go from here?
The Cheshire Cat: That depends a good deal on where you want to get to.
Alice: I don't much care where.
The Cat: Then it doesn't much matter which way you go.
Like Alice, investors have lost their way following the “rabbit down the rabbit hole” for six weeks following the May 2 stock peak, as most of the indices I follow closed lower for each week over that timeframe. I referenced that six-week skein in last week’s strategy comments, noting the S&P 500 (SPX/1271.50) had fallen for six straight weeks for only the sixth time since 1995. If past is prelude, the SPX subsequently experienced decent gains over the ensuing six weeks every time! Worth considering, however, is that the SPX did not trade above its previous reaction high in any of those previous occasions. I also referenced how oversold the equity markets were with only 15.6% of the SPX stocks are above their respective 50-day moving averages (DMAs). Then there were other finger to wallet ratios, like the CBOE Equity Put/Call ratio, which at 0.99 (nearly one “put” traded for every “call” traded) was at its highest ratio (the most bears) in nearly two years. Additionally, the 10-day Put/Call ratio “tagged” 0.78 last week for its most bearish (contrarily: bullish) reading since February 2009. As for sentiment, hereto the numbers are eschewed too bearishly. Accordingly, I continue to think the equity markets are in the process of making a “low.” As stated, “The only question to me, at least in the near term, is if we get a selling climax or a selling dry up?!” The ideal pattern would be for some kind of “pornographic plunge” hour into the 1230 – 1250 zone, but given last week’s action, a “selling dry up” (where the sellers just run out of steam) can’t be ruled out.
Obviously, the drivers of the “stock slide” have been the Greek Gotcha combined with the softer economic numbers. But as repeatedly stated, I just don’t understand why participants were surprised by said numbers since they were telegraphed by Japan’s tragedy (supply chain disruptions), the weird weather (tornados/floods), and a 44% rise in the price of gasoline between January and May. Moreover, I continue to think the economy is “geared” to reset itself. Manifestly, vehicle production is scheduled to ramp 23%+ in July, Japan is doing better, the debt ceiling debacle will be resolved with the attendant outsized spending cuts I have been suggesting, gasoline prices have declined by ~15% from their May peak, U.S. bank loans are increasing, and capex should strengthen in 2H11. That improving capex view is reflected in the Business Roundtables CEO Capex Outlook Survey that also has a high correlation with CEOs’ hiring intentions (read: better employment figures). To be sure, I think the business cycle is still in play whereby profits explode, which drives an inventory rebuild, followed by a capex cycle, and then people get hired.
Reinforcing that view is this insight from our sagacious friends at the “must have” GaveKal organization. To wit: “We would still attach a probability of well over 50% to our core scenario of strong US growth. Our reasons were presented in the Quarterly: huge corporate cash-flows and the weak US Dollar will keep investment and exports booming; bank lending is reviving and starting to trickle down to the crucial small business sector; and employment, retail sales and consumer confidence were all improving strongly, until the temporary setback in the latest figures. We believe this setback was due very largely to the shock of $120 oil. Indeed, we had been warning since January that the combination of the Fed’s easy money and Middle Eastern upheavals was causing severe economic damage. In our view the present global slowdown and correction in financial markets is thus largely an overdue reaction to the unexpected dangers that materialized in the Middle East (and to a lesser extent in Japan and Europe) at the start of the year. The good news is that the most important of these shocks—the oil crisis—is now almost certainly over as the biggest damage to the world economy came not from the direct effect of oil at $120, but from the possibility that the price would jump to $150 or even $200, if political chaos spread to Saudi Arabia, Kuwait or the UAE. With this risk now essentially removed, the Saudis are eager to teach the rest of OPEC (especially Iran) a lesson by maximizing their output and dumping it on the market to keep prices down. Thus a strong rebound is still much more likely than an extended soft-patch, never mind the outright recession for which the bond market is now priced. And that, in turn will probably mean the Fed starts its journey back to monetary normality much sooner than the markets expect.”
As for last week’s action, while it’s true the SPX tested, and held, its 200-day moving average (DMA) at ~1258 on Thursday, the SPX “missed” out on a prime opportunity to build on that upside reversal last Friday. Indeed, Friday’s opening salvo saw the SPX “tag” ~1280 (+13 points) in the first five minutes of trading. From there, however, the market zigzagged its way through the session and struggled to close only ~4 points higher. Disappointing – you bet it was because Friday’s struggle worked off some of the oversold condition and therefore leaves us with a pretty weak stock market trading pattern. In fact, this sort of set-up suggests further weakness into the aforementioned 1230 – 1250 zone. So unless the SPX can better the 1292 – 1296 level, the current configuration favors further downside probing.
The losing sectors for the week were: Materials (-1.96%); Energy (-1.65%); and Information Technology (-1.16%). The winners were: Consumer Staples (+1.20%); Industrials (+1.09%); and Utilities (+1.0%) as the restless rotation extends. Meanwhile the Financials continued to languish. Indeed, of the 10 macro sectors the Financials have been the worst performing, losing some 6.50% year to date. Unfortunately, that leaves my New Year’s “call” that “2011 should be the years of the banks” looking pretty foolish.
Fortunately, I have avoided the underperforming marquee bank stocks, preferring the smaller names like IBERIABANK Corporation (IBKC/$57.09/Strong Buy). Speaking to this “small bank” theme, last week I had dinner with David Ellison, portfolio manager of the FBR Small Cap Financial Fund (FBRSX/$18.67). I used to chat with David back in the 1980s when he hung his hat at Fidelity and managed Fidelity’s Select Financial Fund. Interestingly, David currently owns a number of the smaller banks I have commented on in these missives. Even more interesting is that David is my kind of investor since when he can’t find attractive investment opportunities he is content to hold cash. Case in point, unable to find attractive investments going into the 2008 financial fiasco, David held 60% of his fund in cash. Indeed, my kind of investor. Accordingly, participants wanting to fill the financial sleeve of their asset allocation model should consider David’s fund.
The call for this week: In last week’s comments I noted the SPX had been down for six consecutive weeks for only the 17th time since 1928. As Bespoke Investment Group wrote early last week, “If there is any consolation for the bulls, it is that there have only been three weekly losing streaks of seven or more (weeks) for the index. (After six consecutive weeks down) in week seven, the SPX has risen an average of 1.03%.” While last week’s gain of 0.52% fell short of that average, the SPX did manage to avoid its seventh weekly wilt. Not so for the NASDAQ, which recorded its seventh down week with a loss of 1.03%? I am leery when the NASDAQ doesn’t confirm the SPX’s upside, so unless the SPX closes decisively above the 1292 – 1296 level I am cautious.
Dean Maki, Barclays
Shelter costs, the only significant source of disinflation in the core CPI, continue to rise, pushing core inflation higher.
Alternative inflation measures such as the median and trimmed mean CPI are dominated by shelter costs and are now moving higher.
Recent firming in the core CPI likely raises the bar for further action from the Fed.
The overall CPI increased 3.6% y/y in May, the 19th consecutive month in which overall inflation has risen at a faster y/y pace than core inflation. As we have discussed in previous publications, we believe the trend higher in food and energy costs, and commodities more generally, is being driven in large part by easy global monetary policy, and we expect the trend in overall inflation to remain above that of core inflation. While energy prices have been the largest driver, food prices increased 3.5% y/y in May, and we expect food inflation to break above 5% by year-end.
Shelter costs continue to push core inflation higher
The core CPI reached 1.5% y/y in May, up from 1.3% in April, and the main story continues to be the reversal of shelter disinflation. As we have discussed for some, the disinflation in core inflation was driven by the shelter component (mainly rent and owners’ equivalent rent), but that component is now reversing, driving core inflation higher. The core CPI outside of shelter has shown only modest movements over the past few years. Some FOMC members have disagreed with the view that the disinflation was narrowly focused in shelter, noting that measures such as the Cleveland Fed’s median and trimmed-mean CPI and the Dallas Fed’s trimmed mean PCE index showed significant disinflation, and this was taken as a signal of widespread disinflation. However, we disagree with this reasoning.
These measures strip out the most volatile pieces of core inflation, and shelter is among the smoothest series in core inflation, both because rents are typically only changed once a year and because the Bureau of Labor Statistics bases its measures on 6-month changes for each household, further smoothing the series. This, combined with its large relative importance (41.4% of the core CPI), means that shelter tends to dominate these alternative measures. In fact, in 2007, the Cleveland Fed revised its median CPI methodology because owners’ equivalent rent, the largest component of shelter costs, was the median component 64% of the time. It split the owners’ equivalent rent series into its four regions and said that meant it was only the median component 52% of the time. To us, this means the decline in the alternative measures never did signal that the disinflation was widespread. Not surprisingly, these alternative measures decelerated along with shelter and are now rising as shelter costs move higher.
What was particularly noteworthy about the May CPI report was that several other areas continued to post stronger increases, such as new and used vehicles and apparel. Some of this might be transitory; for example, vehicle prices are likely being pushed somewhat higher by the supply chain disruptions from the Japanese earthquake, but vehicle prices were strengthening well before the earthquake hit. Also, import prices have been surging, and some of this is likely beginning to pass through to the core. For example, imported apparel prices were up 6.6% y/y in May, the largest gain since 1988, and this appears to be starting to pass through to CPI apparel prices (Figure 4). The broad-based strength in the core CPI led us to bump up our core inflation forecast slightly, and we now expect the core CPI to rise 2.0% y/y by Q4 11, up from our previous forecast of 1.8%.
The rise in core inflation raises the bar for further Fed stimulus
The Fed is likely pleased that core inflation is rising, since it is getting closer to its long-run forecast of 1.7-2.0% on the PCE price index. However, the rise in core inflation likely makes it even less likely that the Fed will launch another asset purchase program. Part of the reason for the last asset purchase plan was that it feared further disinflation or even deflation, and it is very difficult to make that argument in light of recent inflation data. Thus, the Fed would need to justify any further easing on economic weakness alone. While recent data have been weak, it still probably expects stronger data in H2 11 and will likely wait for several months to see if that occurs. Only if the anticipated rebound fails to occur is the Fed likely to implement more stimulus. Thus, while we look for the FOMC to take its 2011 growth forecast down somewhat at next week’s meeting, we expect no signal that it is considering further stimulus in the near term.
Jason Pride, Glenmede
Economy Still Unable to Gain Traction Amid Soft Patch
• The U.S. is in the midst of a soft patch, with Fed stimulus about to end and politicians still at an impasse.
• Speculation over QE3 is rising, but this looks extremely unlikely even with the soft patch.
• The slow-down could be temporary, but the risk of a more material slow-down has increased.
• Lessening inflation pressure due to economic weakness is removing emerging markets’ need to tighten.
• Economists and strategists continue to reign in their growth projections, from 3-3.5% to 2.5-3%.
• Leading indicators continuing to roll does not bode well for the economy.
• However, a few indicators have improved: Japan’s industrial production, U.S. lending activity.
Who Knew Can Kicking Was So Hard?
• The IMF/EU appear prepared to provide the next quarterly tranche of €12 billion in aid to Greece.
• However, this is an effort to but time for negotiations of a larger, longer-term plan for Greece.
• Agreement appears to be forming for voluntary purchasing of Greek debt a la the Vienna Agreement.
• The next tranche of Greece aid is contingent on its parliament passing a €28 billion austerity measure.
• Germany blinked first, but still maintains it will look for private bondholder participation going forward.
• Other peripheral nations continue to push ahead with austerity and reform measures.
• Separately, ECB still looks poised to hike rates in July.
Past The Limit, But Nearing Agreement?
• The U.S. debt ceiling has been reached, an important moment for our nation’s debt debate.
• The Treasury is employing evasive actions to avoid breaching that limit before August 2.
• Reports are surfacing that discussions between Republicans and Democrats, led by Vice-President
Biden, are looking promising, and may lead to an agreement being released by early July.
• This would not be the long-term solution, but would buy time and embed incentives to follow through.
• Ongoing 2012 budget negotiations will be injected with political overtones given the election cycle.
• Unease in bond markets is likely to increase if some form of agreement is not reached.