Barclays is optimistic about global growth, while contrarian Jeffrey Saut is holding onto cash, Jason Pride sees unrest in Egypt as a buying opportunity, and Mark Pawlawk at KBW warns about stock plunges are an oil price spike.
Frank Engels, Barclays Capital
For most of 2010, investors, analysts and economists alike worried about what was commonly described as ‘double-dip recession’, triggered by a hard landing in Asia, renewed weakness in the US economy, a widening of the euro area fiscal and financial crisis, or a mixture of those. Now, following a number of reassuringly positive data surprises on economic activity in Asia, the US and the euro area, some of these downside risks seem to be fading, with global growth dynamics likely to gain renewed traction – a view corroborated by the modestly upgraded description of the economy provided by the US Fed and ECB, respectively.
Moreover, tentative signs have emerged that European governments are ready to confront the pending fiscal and financial problems of select member countries and banks more forcefully. The likely rationale for this action would be to ring-fence large peripheral countries such as Spain from the more acute problems faced by smaller ones. If pursued in a timely and coherent fashion, this could prove successful in addressing related investor concerns and reduce tail risks to the sustainability of the economic recovery.
Against this backdrop, and in view of rising global inflationary pressures from elevated food and commodity prices, it becomes increasingly important to look at the remaining slack in the global economy, accompanied by country-specific assessments, to discern what type of policy challenges are likely to emerge over the next few quarters and how this could affect overall financial market sentiment. In fact, in November 2010, our global industrial production series exceeded its previous peak (in February 2008) for the first time since the global financial crisis emerged, and we expect a further increase in global IP over the next months. However, looking at county-specific capacity utilization rates in manufacturing, it is clear that the degree of remaining slack in production varies markedly across countries and regions.
While most developed economies, particularly Japan, are still producing well below the capacity utilization rates seen at the peak of the previous cycle, manufacturers in selected emerging market countries, most notably in Asia and Latin America, are operating at or above previous peaks suggesting that slack has diminished. In Emerging Europe, however, they are, on average, somewhat lower than in the rest of EM, due in part to the larger trade and financial sector linkages with developed Europe. Looking at labor market developments, a similar pattern emerges: most developed countries – with the notable exception of Germany – are still facing substantially higher unemployment rates than at the onset of the financial crisis, while the picture in emerging market countries is more mixed and suggests that less slack prevails overall in their labor markets. Against this backdrop, we estimate output gaps in the US, euro area and Japan to have accounted for approximately 3% of GDP in Q3 of last year, while output gaps in Latin American economies are estimated to have mostly closed last year or are closing in the course of this year. Given the substantial degree of remaining slack in many developed countries, we believe it is less likely that present headline inflationary pressures will quickly pass through to core inflation. This, in turn, should lower the likelihood of a synchronized global tightening cycle in monetary policy and, thus, ceteris paribus, could increase the sustainability of the ongoing global recovery.
By the same token, however, this implies that an increasing number of EM countries will need to strive further to contain demand to avoid overheating and an acceleration of inflation. For the time being, policy measures have focused on monetary tightening and the imposition of capital controls by select countries. In the area of fiscal policies, automatic stabilizers have been at work, and fiscal stimulus programs have mostly expired. However, we would argue that additional discretionary anti-cyclical fiscal policy measures, preferably spending cuts, ought to be contemplated to address the build-up of demand pressures, accompanied by lesser FX interventions with a view to providing for tighter monetary conditions. This implies that economic policy paths are likely to remain very diverse across countries and regions as policy challenges continue to diverge.
Jeffrey Saut, Raymond James Contrarians!?
Good investors are instinctively contrarians! You have to learn to go opposite the mayhem of the markets; and if you are early, it’s indistinguishable from being wrong. It happens to the best of “seers” as it once again has happened to me given my cautious stance as we entered this year. Yet except for the S&P 500’s first day of the year’s “yippee” of 14 points (to 1272), the major averages have basically done nothing. Nevertheless, performance angst caused me to reflect on the early track record of Sir John’s “Templeton Growth Fund,” as described in Barron’s some 30 years ago: “Legendary Sir John Templeton began his fund near the top of the 1955 bull market. He raised $7 million. Then, he promptly underperformed the S&P 500 for the first three years by 17.9%, 8.3%, and 6.7%, for a cumulative deficit of 2.9%. As a result of his dismal record, Templeton wound up in 1957 with only $3 million in the fund, less than half of what he started with; and, his fund was ranked 115th (14th percentile) out of 133 funds in a Wiesenberger study of relative investment performance. He did not get back to (the level of) $7 million until 1969, some 14 years after he began. And the rest, as they say, is history.”
John Templeton’s problem was that he was early in anticipating the bone-crushing decline of 1957 and was therefore investing on a risk-adjusted basis. Indeed, the successful investor has to learn to go against the carping crowd, to be able to see that the Emperor has “no” clothes; and, if you are truly early, and criticized, remember the following quote from Theodore Roosevelt:
“It is not the critic who counts, not the man who points out how the strong man stumbled, or where the doer of deeds could have done them better. The credit belongs to the man who is actually in the arena; whose face is marred by dust and sweat and blood; who strives valiantly; who errs and comes short again and again; who knows the great enthusiasms, the great devotions and spends himself in a worthy cause; who at the best, knows in the end the triumph of high achievement; and who; at the worst, if he fails, at least fails while daring greatly, so that his place shall never be with those cold and timid souls who know neither victory or defeat.”
Clearly, I am in the “arena” since I can be measured to the second decimal point every morning. I am also in the “arena” and subject to criticisms like the one I received referencing last week’s report about dollar cost averaging. The emails read: “As an avid reader of your work, I want to make a comment on your opening paragraph in the weekly Investment Strategy, ‘Fear, Hope, & Greed.’ The interesting request from one of our Financial Advisors (FA) is interesting, but virtually worthless. The overall impression of the 40-month dollar cost averaging exercise is that ‘if our fictional investor had been able to conquer his fear, and had employed a dollar cost averaging strategy, that he would have achieved a whopping 33% out-performance vs. the investor who 'rode it out'.’ This fiction only works if the investor was 100% in cash going into September 2007. Even if clients had taken your sage advice in October 2007 (I recall Tom James referring to you as ‘the smartest guy in the room’), the number that were in 100% cash was very small. If our clients had then been able to invest into the market on a monthly basis the same amount they already had in the market on September 2007 the exercise has HUGE meaning. Most of my clients, however, could not invest 40X the amount they had in equities beginning in September2007. Any investor not so positioned must conclude they did not receive good advice on how to implement Jeff Saut's pre-October 2007 precautionary statements. Yes, those clients we had significantly hedged, or with large cash balances, benefited greatly. As you know, the type of client you can direct to make large position changes like that is also the type of client that moves a significant dollar amount back in after a large drop like in September 2008, and February 2009, does not wait to average back in using equal dollar amounts. Yes, those clients came out better than your ‘fictional investor.’ For those clients not so positioned, do we accomplish enough in potential future client discipline in following hedging, and cash positioning strategies, to justify the negative impact? I really do appreciate your weekly, and daily, comments. I read all of your strategy comments, and listen to your daily strategy verbal comments at raymondjames.com; please keep up the great, intellectually entertaining, and insightful work.”
To be sure, on a superficial basis our emailer’s points are valid, but he missed the point of last week’s missive in that investors need to conquer their FEARS in order to be successful. The other message was to not get caught up in excitements and depression. As Charles Ellis wrote, “Compose a long-term investment policy that is right for the market (and right for you), settle into it, and stay there forever.” Yet, “fear” surfaced again last week as the S&P 500 surrendered 1.8% on Friday. As always, the media looked for a causa proxima, trotting out everything from earnings disappointments to softening economic indicators, but the pièce de résistance was Egypt. Yet the fact of the matter is that the stock market has been sending out “topping” signals for weeks. As I related to a reporter last Friday, “The market was ready to go down and the news backdrop was just an excuse. Still, to me the question is – will this be a 3% - 5%, or a 5% - 10%, decline?”
The answer to that question might be foretold by the always insightful SentimentTrader.com website. Indeed, Jason Goepfert noted that the SPX closed below 1280.26 last Friday, thus completing the pretty rare feat of registering a new 52-week high one day and then collapsing to a 10-day low the next. Jason continues by writing: “Going back to 1928, this has occurred 8 other times. The index’s most consistent performance in the weeks ahead was 26 days later, when it was up 1 time and down 7 times. It suffered an additional loss of about 4% on average during that time. Perhaps most importantly, it took a median of 58 days to climb back enough to close at a new 52- week high. None of them were able to get a new high in anything shorter than 32 trading days, and three of them took 2 years or more to get there.”
Whatever the short-term outcome, the major averages continue to reside above their respective 50- and 200-day moving averages, which is bullish; and the Buying Power/Selling Pressure indices continue to suggest the uptrend remains intact. Accordingly, while we could see some further weakness, it is going to take a lot more than protests in Egypt to break the back of the current uptrend.
Consistent with these thoughts, I am making a shopping list of stocks to own and waiting to see how well they act during any subsequent market decline. Since over the longer-term it is all about earnings, a few names from the Raymond James research universe that beat their earnings estimates, and guided earnings estimates higher, last week include: Altera; Celestica; Intel; Skyworks; Stanley Black & Decker; and Tempur-Pedic.
The call for this week: John Templeton once remarked, “For those properly prepared in advance, a bear market in stocks is not acalamity but an opportunity.” And while I don’t think this is just a counter-trend rally in an ongoing bear market, I continue to believe we are into an uptrend within the context of the wide-swinging trading range stock market we have experienced since the turn of the century. Of course there will be pullbacks, which is what I have been preparing for since the beginning of 2011. This is also consistent with my advice of the past 11 years that investors need to be more proactive in their investment strategies. That strategy is confirmed by the astute Bespoke Investment Group’s study of last weekend that shows a more proactive approach has beaten a buy and hold strategy since the March 2009 “lows,” as can be seen in the chart on page 3. While I don’t think ANYONE can trade the stock market on a daily basis, Bespoke’s study makes the argument for a more tactical approach to investing. That includes raising cash at the appropriate times, hedging long investment positions that may decline significantly during broad market declines, avoiding getting too bullish and too bearish, and above all not letting ANYTHING going more than 15% - 20% against you.
Currently, I have a decent cash position and look to redeploy that cash on any subsequent decline.
Jason Pride, Glenmede
“An Egyptian Conniption”
Violent protests erupted in Egypt causing geo-political uncertainty. As is typical with any Mideast conflict, oil prices rose and investors sold risky assets.
Geopolitical risk has historically led to temporary market weakness - opportunity for buyers. While the US is ideologically linked to the democratic movement that underlies the protests, its Mideast allies, Jordan and Saudi Arabia, are likely weakened by the outcome.
From Jobless Recovery to Job-Full Expansion?
Initial claims data had been steadily improving, but has paused in recently due to weather.
Employment growth, the key ingredient to a sustained economic expansion, should continue.
The Debt Deadline Approaches
The national debt limit (currently $14.3 trillion) is expected to be reached in early March.
This sets up the 112th Congress’s first major battle over the debt/deficit issue.
The White House and Democrats will likely have to make concessions in order to get the Republican House to vote to raise the debt limit – the question is what and how much.
The President’s State of the Union Address called for a 5-year non-security spending freeze.
The development of a long-term debt/deficit reduction plan in the US is the key to 2011.
The President’s Budget, submitted in 2 weeks, will be the opening salvo in the debt battle.
To Deleverage or to Consume: That Is the Question
The GDP report on Friday: GDP growth of 3.2% but personal consumption growth of 4.4%.
The savings rate dropped; now below 5.5% from almost 6%, a change in savings plans?
Consumption is the keystone of the economy, but deleveraging is necessary to make the consumer’s path sustainable.
Europe: Status Quo
Inflation is expected to remain slightly above the ECB’s comfort zone.
Politicians seem to be (slowly) working towards an expansion of the EFSF.
Pressure on the PIIGS looks to have eased for the immediate future.
Tensions still elevated, and a lasting resolution to debt problems has yet to be found. ECB will react only to a catastrophic economic/financial event or a diminution of inflation.
Mark Pawlak, Keefe, Bruyette & Woods,
Oil Spikes and Their Effect on Stocks with a Focus on Financials
Given the turmoil in Egypt which follows the unseating of Tunisia's president, we think it is worth considering the effects of a spike in oil prices on the broader equity markets and, more granularly, the financials. Given that several recent recessions have been preceded by oil shocks, it shouldn't be surprising that equities underperform in the face of significantly higher oil. We find that from 1961 to present, the frequency of underperformance for the S&P 500 and the Keefe Bank Index in the face of an oil shock is not notable. However, the average underperformance of both in the face of higher oil is significant in our opinion with the KBI's average underperformance being larger than that of the SPX.
Questions about the Middle East's stability have raised amongst other things the specter of an oil spike. Last Friday alone oil futures were up over four percent.
Forbes estimates that a closure of the Suez Canal would result in an extra 6,000 miles of transportation for oil supplies out of the region which would in our opinion result in heightened costs for oil.
In the past oil spikes have preceded recessions in 1973-74, the late 70s and early 80s, the early 90s, and 2008-2009.
In the sixteen instances over our time frame that crude oil rose more than twenty percent on a quarter over quarter basis, the SPX was evenly split between higher and lower quarter over quarter closes. The average return in those sixteen instances was 0.50% or an underperformance of 133 basis points.
The KBI was lower in nine instances and higher in seven. The average return in those sixteen time periods was -1.04% or an underperformance of 308 basis points. When oil dropped over twenty percent over our sample period, the KBI had far more frequent gains than losses, six to two and with returns averaging 10% outperformed by nearly eight hundred basis points. In contrast, for gains in oil over 20%, the SPX only outperformed by nine basis points gaining on six out of eight time frames.
The unrest in Egypt late last week rattled markets and has caught the world's attention. On the heels of the recent unseating of Tunisian President Zine al-Abidine Ben Ali, questions about the Middle East's stability have raised amongst other things the specter of an oil spike. Last Friday alone oil futures were up over four percent. Even without a disruption in supply, Forbes estimates that a closure of the Suez Canal would result in an extra 6,000 miles of transportation for oil supplies out of the region which would in our opinion result in heightened costs for oil. In the past oil spikes have preceded recessions in 1973-74, the late 70s and early 80s, the early 90s, and 2008-9.
Given that equity markets are considered a forward looking indicator of economic activity, we decided to look at the price relationship between crude oil and the S&P 500 as well as the relationship between crude and the Keefe Bank Index (KBI), a precursor to the KBW Bank Index from 1961 until today. Given that both oil and equities have gone up in price over our chosen time period, it shouldn't be surprising that the correlation over the full time frame on a closing quarterly basis between West Texas Intermediate crude oil (WTI) and both the SPX and the KBI is positive. The correlation between the SPX and WTI is tighter at 0.688 than that of the KBI and WTI which comes in at 0.586. Within our time frame, however, when using a trailing 30 month correlation, oil and equities go through periods of significant positive and negative correlation.
The question that enters our mind is whether equity markets anticipate a recession when oil spikes. We looked at price movements in the SPX and the KBI when oil moved more than 10% and twenty percent higher on a quarter over quarter basis. As a point of reference, the average quarter over quarter percentage moves for WTI, the SPX, and the KBI were 2.87%, 1.83%, and 2.04%. In the sixteen instances over our time frame that WTI rose more than 20% on a quarter over quarter basis, the SPX was evenly split between higher and lower quarter over quarter closes. The average return in those sixteen instances was 0.50% or an underperformance of 133 basis points. The KBI was lower in nine instances and higher in seven. The average return in those sixteen time periods was -1.04% or an underperformance of 308 basis points. During the recovery from the financial crisis, most financial assets had a strong positive correlation. The SPX and the KBI were up 15.22% and 34.56% for the second quarter of 2009. If that quarter is eliminated in our calculation of equity performance in the face of an oil spike of twenty percent or more, the average return for the SPX was -0.48% or an underperformance of 181 basis points. The underperformance for the KBI is worse without that quarter moving to -3.41% or an underperformance of almost five and a half percent.
In looking at a rise of more than ten percent on a quarter over quarter basis for WTI, the SPX closed lower in sixteen of forty-two instances for an average performance of 1.07% or an underperformance of seventy-six basis points. In contrast, the KBI's results were very similar to that of its performance in the face of a twenty percent rise. Twenty-three of forty-two times the KBI was lower for a loss of one percent or only four basis points higher than when WTI was twenty percent higher on a quarter over quarter basis.
To summarize, in the face of an oil spike of above ten percent, both the S&P 500 and the Keefe Bank Index on a quarter over quarter basis underperformed their average return between 1961 and now. The underperformance was more notable for the KBI than the SPX. Additionally, while the returns on the SPX improved when the hurdle was moved from an oil rise of twenty percent to only up ten percent, those of the KBI were barely changed. Finally, it is worth noting that in terms of frequency, neither the SPX nor the KBI showed a significantly higher number of losses than gains over our sample period indicating that the losses tended to be more significant.
As a final aside, interestingly enough, when oil dropped over twenty percent over our sample period, the KBI had far more frequent gains than losses, six to two and with returns averaging ten percent outperformed by nearly eight hundred basis points. In contrast, for losses in oil prices over twenty percent, the SPX only outperformed by nine basis points gaining on six out of eight time frames.
Below we have the performance of KBW's indices and their correlation with oil. We are of the view that the plummet of asset prices during the financial crisis and their subsequent rebound created more positive correlations amongst most of what we would call risk assets, i.e. commodities, credit, credit-sensitive MBS, and equities.
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