BlackRock's Weekly Investment Commentary from Bob Doll, Vice Chairman and Chief Equity Strategist for the week of July 26, 2010.
US equities posted positive results last week as uncertainty continued to ease in the markets. Funding conditions in the euro’s non-core countries have improved, activity out of the European economies has been better than expected, US earnings reports have been strong and we have seen the passage of the European bank stress tests. Overall, the Dow Jones Industrial Average gained 3.24% last week to close at 10,425, the S&P 500 Index advanced 3.55% to 1,103 and the Nasdaq Composite rose 4.15% to 2,269. Factoring in these results, US equity markets extended their gains for the month of July to more than 7%.
Notably, the major short-term ambiguities that kept market participants on the fence — the US banking bill, growth in China, the EU bank stress tests and European sovereign funding — have abated to some degree for the time being. The US bank bill has become law, but it will take years to gauge the impact of the more than 2,000 pages of text; China’s growth has slowed to 7% or 8%, reducing the need for much further tightening; and European funding pressures have softened as non-core banks are starting to get access to the bond market and are able to borrow more in the interbank markets.
In terms of earnings, 30% of S&P 500 companies have reported their second quarter results, and the magnitude by which reporting companies exceeded analyst estimates is the fourth-highest on record. Reported earnings so far are more than 13% higher than expected on a dollar-weighted basis due to both top-line strength and continued margin improvement. The breadth of revenue results beating expectations also has been high.
Positive surprises in the data are obviously based on past information. For asset prices to rise, there has to be increases in future expectations about earnings and cash flow. In the case of the United States, we are getting a limited amount of that. While earnings are quite good, the follow-on has been to raise estimates consistent with the beat, at most, with no increase seen in the second half of the year.
Turning to politics, absent an exogenous event that radically shifts the political landscape, Democrats will likely suffer significant losses in the mid-term elections. Even if they retain majorities in both chambers, their margins likely will be so small that they will lose their governing majorities, making it unlikely that Congress will pass anything controversial next year without bipartisan support.
There is a potentially bullish shift afoot on the Bush tax cuts. Many, including us, have thought that the cuts would be extended for individuals with under $200,000 in income, and for families with less than $250,000. However, support is growing among some Democrats for extending the tax cuts to everyone.
The US Fed marked down its estimates for inflation and real gross domestic product for 2010 and 2011, and acknowledged that the unemployment rate may decline more slowly than previously expected. In recent testimony, Fed Chairman Ben Bernanke barely acknowledged the recent disappointment in US economic data and also downplayed the growing risk of deflation. His message is that the bar is set fairly high for more monetary stimulus.
Our view remains that a sustained, albeit subpar, economic recovery is in the cards. We are watching the indicators carefully for signs of a more negative path for the economy. At this time, neither critical equity sectors nor credit spreads are signaling that the recovery has been derailed, which suggests to us that the cyclical recovery in corporate profits is not over. Still, the US economy continues to face significant headwinds, giving us reason to believe that the move higher in equity and other risk asset prices will likely be a long, hard grind characterized by continued volatility.
Inflation vs. Deflation, from Jeremy Grantham, chief investment strategist, GMO
I, for one, am more or less willing to throw in the towel on behalf of Inflation. For the near future at least, his adversary in the blue trunks, Deflation, has won on points. Even if we get intermittently rising commodity prices, which seems quite likely, the downward pressure on prices from weak wages and weak demand seems to me now to be much the larger factor. Even three months ago, I, like many, was mesmerized by the potential for money supply to increase dramatically, given the floods of government debt used in the bailout. But now, better late than never, I am willing to take sides: with weak loan supply and fairly weak loan demand, the velocity of money has slowed, and inflation seems a distant prospect. A weak economy and declining or flat prices are the prospect for the immediate future.
The worrying news is that most European countries, led by Germany (not surprisingly in this case), are coming on more like Hoover than Keynes. More surprisingly, Britain and half of the U.S. Congress are acting sympathetically to that trend, which is to emphasize government debt reduction over economic stimulus. Yet, after a relatively strong initial recovery, the growth rates of most developed economies are already slowing, despite the immense previous stimulus. You don’t have to be a passionate follower of Keynes to realize that to rapidly reduce deficits at this point is at least to flirt with a severe economic decline. We can all agree that we had a financial crisis, a drop in asset values, and an economic decline, all three of which were global (although centered in the developed countries), and all three of which were the worst since the Great Depression. All three were destined to head a whole lot deeper into the pit without the greatest governmental help in history, also global. Yet despite this help, the economic recovery was merely adequate, unlike the stock market recovery, which was sensational and, as often happens, disproportionate to the fundamental recovery.
But in the last three months, more or less universally in the developed world, there has been a disturbing slackening in the rate of economic recovery. (Perhaps Canada and Australia on their own look okay, propped up by raw materials and, so far, un-popped housing bubbles.)
I am still committed to my idea of April 2009 that there would be a “last hurrah” of the market, supported psychologically by a substantial economic recovery but then, after a year or so, that this would be followed by a transition into a long, difficult period. I had, though, supposed that the economic reflex recovery – how could it not bounce with that fl ood of governmental help to everyone’s top line? – would last longer or at least not slow down as fast as we have seen in the last few weeks. And with unexpectedly strong fiscal conservatism from Europe and perhaps from us, this slowdown looks downright frightening.
At GMO, our asset allocation portfolios, however, are merely informed on the margin by these non-quantitative considerations. They draw their strength from our regular seven-year forecast. Today this forecast suggests that it is possible to build a global equity portfolio with just over the normal imputed return of around 6% plus inflation. With our forecast, this can be done by overweighting U.S. high quality stocks and staying very light on other U.S. stocks. At a time when fixed income is desperately unappealing, this, not surprisingly, results in our accounts being just a few points underweight in their global equity position, which is suddenly a little nerve-wracking as the growth of developed countries slows down. A little more dry powder suddenly seems better than it did a few weeks ago, but then again, prices are 13% cheaper. But even as global equities approach reasonable prices, I would err on the side of caution on the margin.
Let me give a few more details: just behind U.S. high quality stocks, at 7.3% real on a seven-year horizon, is my long-time favorite, emerging market equities at 6.6%. This is now above our assumed 6.2% long-term equilibrium return. Additionally, my faith in an eventual decent P/E premium over developed equities exceeding 15%, perhaps by a lot, is intact. Emerging equities’ fundamentals also continue to run circles around ours. EAFE equities at 4.9% are a little expensive (6% or 7%) but make a respectable filler for a global equity portfolio. Forestry remains, in my opinion, a good diversifier if times turn out well, a brilliant store of value should inflation unexpectedly run away, and a historically excellent defensive investment should the economy unravel. Otherwise, I hate it.
Time to Rebalance, From Jeffrey Saut, chief investment strategist, Raymond James
I think we are approaching a point where rebalancing portfolios may be in order. To wit, the June “closing highs” for the DJIA and the DJTA were 10450.64 and 4467.25, respectively. Currently, both averages are approaching those levels. Either both averages will break out above their June highs (a Dow Theory buy-signal), one will break out and the other won’t (an upside non-confirmation), or both will fail to close above their June highs (trouble). Meanwhile, my proprietary intermediate-term trading indicator is still flashing caution, as are the stochastic and 12-month moving average indicators. That said, I have been constructive on the stock market since the beginning of July despite the parade of negative indicator events registered since the April peak. My bullishness was driven by the most oversold reading since the “capitulation alert” of October 10, 2008 when 93% of stocks traded on the New York Stock Exchange made new annual lows. Regrettably, the extreme oversold condition that existed three weeks ago has now been largely erased. Accordingly, this week shapes up as a pivotal week and I will be watching the action closely.
While in the short-run the stock market is a beauty contest (picking the “prettiest” stock), over the long-run it is a weighting machine. Plainly, the “weighting machine’s” metric is earnings. To that point, this earnings season has been pretty good with about 76% of the S&P 500 companies reporting positive earnings surprises and ~70% showing upside revenue surprises. Interestingly, of the S&P’s 10 macro sectors, Technology’s weekly forward earnings per share are at a record high. Since the bottoming process began (October 2008) I have emphasized technology stocks. Most recently, I have talked about Microsoft (MSFT/$25.81) and the potential for a huge upgrade cycle. I like tech! Remember, however, that in the short-run the stock market is a beauty contest and what happens this week, as we approach the June reaction highs, should determine the near-term price action for most individual stocks.
Consumer Debt Alert, From Charles Biderman, CEO, TrimTabs
Why are consumers so gloomy? We think the main reason is because they are generating a lot less income to service near record levels of debt.
The after-tax income of all U.S. individual taxpayers was $5.92 trillion in the four quarters ended Q2 2010, down 11.6% from the peak of $6.69 trillion in the four quarters ended in Q3 2008 (we use trailing four-quarter periods to smooth quarterly volatility). Yet household debt in Q1 2010 was $13.97 trillion, down only 4.1% from the peak of $14.57 trillion in Q3 2008.
Taking a longer-term view, after-tax income rose 18.2% from the four quarters ended in Q1 2002 to the four quarters ended in Q2 2010. Yet household debt skyrocketed 71.0% from Q1 2002 through Q1 2010. The economic expansion in the mid-2000s was mostly the result of a credit bubble, fueled by the easy money policies of the Fed.
As debt has held fairly steady and after-tax income has declined, the ratio of household debt to after-tax income in the trailing four quarters has increased to 2.4, the highest level in our records. No wonder households are feeling squeezed.
We think the investors still expecting a strong economic rebound are living in fantasyland. Consumption accounts for about 70% of the U.S. economy. Absent a technological breakthrough like the development of the Internet, what will fuel growth given that consumers face near record debt and declining after-tax income?
Emerging economies will provide some growth for U.S. companies, but these economies are still relatively small, and most of them are geared toward producing goods—and increasingly services—for Americans and other Westerners. If the U.S. economy slumps this year as the stimulus sugar high fades, we doubt emerging economies will be spared pain.
REPORTS CALENDAR
Monday, July 26:
June Chicago Fed National Activity Index, June New Home Sales
Corporate earnings: Advent Software, Legg Mason, Mercer Insurance Group
Tuesday, July 27:
Retail Sales (weekly), July Conference Board Consumer Confidence Index, July State Street Investor Confidence Index, May S & P/Case-Shiller Home Price Index
Corporate earnings: Aetna, Aflac, Deutsche Bank, Fiserv, Kansas City Southern, Teva Pharmaceutical, UBS
Wednesday, July 28:
Mortgage Applications (weekly), June Durable Goods orders, Federal Reserve Beige Book
Corporate earnings: Ameriprise Financial, Lazard, Morningstar, Symetra Financial, Visa, Waddell & Reed, WisdomTree
Thursday, July 29:
Jobless Claims (weekly)
Corporate earnings: Artio, Forrester Research, Franklin Resources, Genworth Financial, MetLife, Moody’s
Friday, July 30:
GDP (second quarter advance report), Employment Cost Index (second quarter), July Consumer Sentiment
Corporate earnings: Aon, Oppenheimer Holdings
