BlackRock's Weekly Investment Commentary - by Bob Doll
Equities took a break from their four-week run and consolidated gains last week, posting very slight losses. The Dow Jones Industrial Average was off 0.3% to close at 10,829, the S&P 500 Index dropped 0.2% to 1,146 and the Nasdaq Composite fell 0.4% to 2,370.
Over the past several weeks, economic data has shown signs of improvement, suggesting that the risks of a double-dip recession are lessening. Last week’s good news included the Chicago Purchasing Managers’ Index for September, which showed increases in both production levels and new orders.
Additionally, initial unemployment claims declined, a positive for the beleaguered labor market. Outside the United States, data from Germany pointed to a stronger-than-expected recovery and we also have been seeing reasonably firm data from China.
Looking ahead, we expect to see some continued back and forth in economic data. The Federal Reserve is likely to continue to support growth through its policies of ensuring that liquidity remains ample. On the other hand, however, the slowing of the rebound in business inventories, constraints from private sector deleveraging and balance sheet contraction from the banking system will act as headwinds.
On balance, we believe that modest (but positive) levels of economic growth will continue, and in the United States, our 12-month forecast is for real gross domestic product growth of somewhere between 2% and 2.5%.
If this forecast is accurate, these growth levels should be enough to maintain strength in corporate earnings. Corporate balance sheets remain healthy, as most companies have remained very conservative in terms of managing their debt and spending levels. Corporate confidence remains somewhat shaky, but should economic growth continue to improve, companies will likely become more aggressive in deploying their high levels of cash on such activities as dividend increases, share buybacks, capital expenditures, merger-and-acquisition activity and (hopefully) hiring. Over the course of the next year, we expect to see continued improvements in corporate earnings and believe the earnings per share for the S&P 500 could be around the $90 level in 2011, which would represent a roughly 8% increase from the $83 level we are forecasting for this year.
For several months, we have been highlighting the increasing disconnect between the S&P 500 earnings yield and investment-grade bond yields. That disconnect has now spread to the high yield bond sector as well. Treasury yields have declined over the past several months as both recession risks and the likelihood for additional Fed bond purchases increased. At the same time, corporate bond spreads have remained relatively unchanged, which has brought investment-grade corporate bond yields to record lows and high yield bond yields to lows they last reached in the pre-credit crisis environment of 2007. As a result, the S&P 500 Index is offering an earnings-per-share yield that is as high as high yield bonds, a very unusual scenario and one that speaks to the attractive relative value of stocks.
UBS Wealth Management Research, Municipal Bonds
Bumps in the Road (Overview)
• The muni market is in transition. In this follow-up to "Municipal Bonds: The Road Ahead," we explore some issues that could affect the fundamentals of muni credit quality going forward - bumps in the road, so to speak - that could lead to a gradual erosion in credit strength.
• In the recession's aftermath, muni finances remain hampered by lower revenues, rising spending requirements and fewer reserves. State and local governments generally take longer to recover from a recession than the nation as a whole. We expect headwinds to linger for some time.
• We continue to believe that defaults are likely to remain limited and concentrated in weaker sectors of the market. Most high quality borrowers benefit from a fair amount of financial flexibility (even in stressed times) that can be directed at implementing the tougher actions necessary to achieve budget balance.
• Some borrowers may need to identify creative ways to do more with less, but we would not expect this to compromise their ability or willingness to make debt service payments to bondholders. Rating pressure remains high in our view.
Our outlook for municipal finances is influenced by what we characterize as an era of limited resources. Greater regulatory scrutiny, tax-policy debates, pending legislation, interest rate risk and market technicals also affect our analysis. We suggest three broad trends that warrant attention:
1. Less market liquidity for unfamiliar names;
2. A flight to simplicity (and quality) by both issuers and investors; and
3. Renewed focus on public-private partnerships to balance budgets.
Careful credit selection is more important than ever. We conclude with our municipal market sector preferences in order to assist investors in better understanding the relative risk profile across the broader municipal market.
Raymond James Investment Strategy
"Churn! Churn! Churn!"
October 4, 2010
To everything - churn, churn, churn
There is a season - churn, churn, churn
A time to win a time to lose,
A time to stand around and be confused
Over the years I have often adapted the lyrics from The Byrds’ classic song “Turn! Turn! Turn!” for the stock market’s action. Currently, the equity markets are indeed churning slightly above their topside “breakout” levels, having pierced previous reaction highs. That begs the question, “Is this an upside breakout; or, an upside fake out?” As stated in previous comments, I think it is an upside “breakout,” implying there should be more upside to come. In fact, if we get through the next few weeks without some kind of major pullback, you are going to start hearing about the strong upside seasonality of November/December.
If correct, participants need to know how to position themselves into year-end. My friends at the sagacious GaveKal organization frequently say there are three ways to make money in the financial markets: “return to the mean trades,” “momentum trades,” and “carry trades.” To wit:
1. “Through Return to the Mean Strategies: The first way to make money in the financial markets is to buy what is undervalued/oversold and to sell what is overvalued/overbought and wait for the asset price in question to return to its historical mean. This is the strategy adopted by most ‘value’ managers, but also frequently a number of ‘macro-funds’, ‘distressed-debt’, ‘special-situations’, etc.
2. Through Momentum-Based Strategies: The second way to make money in the financial markets is to identify a trend and get in (and out) at the right time. Most money managers do try to invest following momentum, but it is especially prevalent amongst ‘growth’ investors, ‘macro-funds’, and ‘long/short’ hedge funds.
3. Through Carry Trade Strategies: The third and final way to make money in the financial markets is to play intelligently the yield curve (i.e., borrow at low rates and lend at higher rates . . . and hope that the markets remain continuous). Most of the ‘arbitrage’ types of hedge funds run some kind of ‘carry trade’. To be sure, I agreed with the good folks at GaveKal, yet I was reminded of GaveKal’s views by a research note from ISI’s always insightful Jeff deGraaf, who writes: “As the market breaks through 1131 it attracts two types of players: ‘breakout’ (momentum) buyers and ‘overbought’ (mean-reversion) faders (sellers) of strength. Much like the value investor sells to the growth investor on the way up, and the growth investor sells to the value investor on the way down, the interaction between momentum and mean-reverting is much the same. It is here that we find the current market battling between mean reverting sellers and momentum buyers. The market’s reaction to news suggests (the) sellers will exhaust themselves, and buyers will dominate as they are forced to play, but a little momentum would sure be welcome (right) here.”
From Jeff deGraaf’s mouth to God’s ears because a breakdown by the S&P 500 (SPX/1146.24) below its 10-day moving average (DMA) at 1141 could lead to a rapid downside test of the 200-DMA (1118) and maybe even a test of the 50-DMA at 1105. Whatever the near-term outcome, I don’t think the equity markets have much downside in them. Indeed, just last week the D-J Transportation Average (TRAN/4509.08) confirmed the D-J Industrial Average (INDU/10829.68) by bettering its August 9, 2010 closing high, a feat accomplished by the Dow on September 20th. Accordingly, the Dow Theory “buy signal” that was registered in July was reconfirmed last week, suggesting the stock market’s trend remains “up.”
I heard from yet another friend last week when Sam Stovall appeared on CNBC. His topic was the correlation between the large cap SPX and the small capitalization Russell 2000 (RUT/679.29). Sam stated, as paraphrased by me: We compared the correlation between the SPX and the RUT for the past 30 years on a rolling 36-month basis. In
December 1987 the correlation was at an all-time high of 94. It subsequently fell to a low of 52 in February 2002. Since then, the correlation has again risen to a current high of 94. If you believe in reversion to the mean, as I do, it suggests correlation should fall from here implying small caps will underperform large caps going forward. Additionally, small caps tend to dramatically outperform in the first year of a bull move, while outperforming to a lesser degree in the second year. In the third year of a bull move large caps outperform.
Sam’s conclusion was that you likely want to underweight small caps and overweight large caps. Obviously I agree. Meanwhile, the weird weather conditions continue as reflected in a 113° day in Los Angeles last week, floods along the east coast, monsoons in Pakistan, and droughts in Russia/China. In fact, according to CNN: “In northern China this month, farm fields have developed cracks up to 10 meters (32.8 feet) deep. Farmers in Chifeng city have had to delay harvests to avoid injury, the state-run Xinhua news agency reported. According to the Chifeng's hydrological bureau, 62 percent of the city's 51 reservoirs have run dry. More than 250,000 people are short on drinking water. In southwest China's Guizhou province in August, a drought affected more than 600,000 people and nearly 250,000 heads of livestock. Parched soil in rice fields was covered with cracks. Beijing's water shortage will soon reach 200 million to 300 million cubic meters, even as the city waits for a new diversion of water from southern China, according to state-run media.”
Regrettably, these tragedies play to my longstanding investment themes of water and agriculture. The unusual weather, however, is not being caused by global warming but rather a La Niña weather pattern combined with more volcanic activity than I can remember. Those eruptions have spewed huge amounts of volcanic ash into the atmosphere. That combination has caused the “tropics” (Tropic of Cancer and Tropic of Capricorn) to extend beyond their usual territories. In turn, the Hadley cell winds, which are shaped by the tropics, are out of whack and thus so are the trade winds. And that, ladies and gentlemen, explains the ongoing weird weather. I revisit this subject because the cold months are approaching; and, if you think last year’s winter was unusually cold just wait for this year’s. Consistent with this view, I continue to recommend overweighting energy stocks in portfolios. My favorites in the energy space are: E&P company Clayton Williams Energy (CWEI/$50.68/Outperform); offshore driller Noble Corporation (NE/$33.50/Strong Buy); equipment provider National Oilwell Varco (NOV/$45.18/Strong Buy); coal company Alpha Natural Resources (ANR/$42.50/Strong Buy); and for yield I continue to like 6.9%-yielding Inergy L.P. (NRGY/$40.43/Strong Buy). For more adventuresome types, I suggest looking at the SPDR Metals & Mining ETF (XME/$54.50), which invests in precious metal and coal stocks, consistent with my longstanding bullish views on those sectors.
The call for this week: There is another reason the markets may continue to rally, Congress is set to adjourn. Remember, “No man’s life, liberty, or property is safe while Congress sits.” That old “saw” is particularly poignant this year as Congress passed a
2,100-page financial reform bill that didn’t address the two serial financial offenders— Fannie Mae and Freddie Mac. Next was the 2,700-page healthcare bill, which nobody read, that didn’t cover healthcare’s biggest cost—frivolous law suits (read: tort reform).
Speaking of not reading, the Senate has passed a bill with no title. H.R. 1586 sailed through the Senate with the title “The ______Act of ______” – oops! Meanwhile, contract law has been absolved, along with constitutional law (read: GM bond holders and the Healthcare Bill), causing one old Wall Street wag to exclaim, “Who’s driving this boat?” The upcoming mid-term elections therefore become monstrously important. Whether it happens, I can make the argument that the Republicans “take” the House, and come close to retaking the Senate, causing politician President Obama to pull a President Clinton and move to the “center.” If that happens, I think the SPX could be at 1300 quickly!
Keefe Bruyette & Woods, North American Equity Research
KBW TARP Tracker
October 1, 2010
The Treasury's TARP program officially expires on the second anniversary of its enactment on October 3. As a result, we update our TARP Tracker to review the cost and returns to the Treasury to date from the TARP program. Specifically we review the TARP CPP program, the primary program supporting banks.
• TARP Two Years Later. The TARP program officially expires on 10/3, but we note that the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act effectively already ended the TARP program by reducing the funds available to $475 billion (from $700 billion), and mandating that unused funds could not be used for any new programs.
• The Treasury continues to garner positive returns on TARP CPP investments.
Treasury invested $205B in 707 banking institutions, received repayments totaling nearly $148B, earned income of $13B from 72 banks that fully repaid CPP (inclusive of warrant disposition), and posted losses of $2.3B. The Treasury currently has $55B remaining in outstanding CPP capital investments in 610 banking institutions. There were missed interest payments on $3.6B or 7% of the $55B in remaining CPP capital investments.
• For the 72 banks that fully repaid CPP (inclusive of warrant disposition),
Treasury's average Return on Investment (ROI) is 10.4%, with eight investments yielding ROIs >=20%: First ULB Corp. (29%), Centra Financial Holdings (28%), FPBF (26%), AXP (23%), LNC (23%), FMWC (21%), GS (20%), and HIG (9%). SBIB's $125M CPP TARP investment has the lowest ROI of 2.9%.
• Since the 69th edition of the TARP Tracker, four banks repaid their TARP investment: First Eagle Bancshares ($7.5M), Liberty Financial Services ($5.6M), First Choice Bank ($5M), and IBC Bancorp ($4.2M). Additionally, two banks auctioned their warrants: HIG ($714M), LNC ($217M), and two banks repurchased their warrants: First Eagle Bancshares ($0.4M), and First Choice Bank ($0.1M).
• The Treasury Posted $2.3B Loss on CPP Investments in CIT and Pacific Coast National Bancorp. Under CIT's 12/10/09 bankruptcy reorganization plan, Treasury's preferred stock and warrant CPP investment were replaced by contingent value rights
(CVRs), which later expired without value on 2/8. As a result, the Treasury's $2.3B investment in CIT is a loss. Further, on 2/11, Pacific Coast National Bancorp dismissed its bankruptcy proceedings with no recovery to the Treasury for the $4.1M in TARP it received.
• TARP dividend payments totaling $41.7M are not expected from six institutions (CIT, Midwest Bank Holdings, Pacific Coast National Bancorp, Sonoma Valley Bancorp, Commerce National Bank, and UCBH Holdings).
One hundred twenty-three institutions failed to make the most recent TARP dividend payments due in August. Also, OSBC announced the suspension of TARP dividend payments on its $73M in TARP preferreds.
Monday, Oct. 4: Pending Home Sales Index, from the National Association of Realtors
Tuesday, Oct. 5: ISM-Non Mfg Index, from the Institute for Supply Management
Wednesday, Oct. 6: ADP Employment Report, Automatic Data Processing
Thursday, Oct. 7: EIA Natural Gas Report, US Dept. of Energy
Friday, Oct. 8: Wholesale Trade, US Department of Commerce
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