Wednesday, September 30, 2009

Ooops! Business Week's Front Page

"Why The Market Will Keep Going Up" ????? Or " Why The Market Is Going Nowhere"?

Does it mean something?

Even Goldman Sees Case For Deflation Stronger Than For High Inflation

Reflation strategists at Goldman Sachs should be wondering about their own economists, as economists in a report published last night conclude:

Should a regime shift in inflation occur in the next few years, the case for deflation looks stronger than for high inflation. Spare capacity could remain elevated well into the next decade if our baseline view of a muted recovery in demand is correct, let alone in the case of a "double-dip" recession. This could eventually pull core inflation and inflation expectations into negative territory, reinforcing a downward spiral.

The US outlook has worrying similarities with Japan's "lost decade" of stagnation and deflation, which also began with a bursting asset bubble and featured a full-blown banking crisis. However, the United States is fortunate - at least on a relative basis - to be dealing with a considerably smaller bubble and has mounted a far more aggressive policy response. Rapid stabilization of the economy and financial system, combined with low and stable inflation expectations (thus far) should help the economy avoid a regime shift in inflation.

In contrast, media and investor attention tends to focus on perceived parallels to past high-inflation or even hyperinflationary environments. For instance, the 1970s "stagflation" in the United States also featured volatile commodity prices, big federal deficits, and deep recessions. But the persistently high inflation that marked this era had its origins in the overheating boom economy of the late 1960s, in stark contrast to today's environment of high unemployment and idle production capacity. Hyperinflationary episodes share with the United States the common trait of huge government budget deficits, but it is the monetization of deficits that truly set hyperinflations apart. The Fed's recent balance sheet expansion notwithstanding, money growth in the United States is an order of magnitude lower than in a typical
hyperinflationary prelude.

FT Alphaville features more food for both inflationists and deflationists.

So the plants of "sweet spot" are seeded, as foolish bond investors will fund the reflation trades of capitalistic strategists?

Tuesday, September 29, 2009

Citi's Small & Mid Cap Investor Survey

Indeed, "the bulls are back"... Here is the summary:
“Buy The Dips” Mentality Seems Likely to Persist — Bulls were abundant in our latest quarterly survey of small/mid cap investors, conducted 9/21- 9/25/09. 67% think small/mid cap stocks will gain at least 3% in 4Q09 with just 11% looking for modest declines. For 2010, 82% expect gains beyond 3% (including 42% anticipating +10-20%). Just 6% are looking for 2010 declines.

Fuel For Optimism — Despite double digit gains in the small/mid cap indices since our June survey, valuations are still perceived as attractive by 58%, while EPS surprises are anticipated in the upcoming reporting season by 89%. Employment & economic assumptions are also improving. On average, our survey participants are expecting 3% real GDP growth in 2010 (vs. 2% in our 6/09 survey). 44% say the Fed won’t raise rates until 2H10, with another 18% saying the Fed won’t act until 2011 or beyond. 56% think employment will start to improve in 2010. Just 21% expected improvement in 2011 or beyond.

Divided Thoughts on the Global Growth Trade — Our latest survey respondents still embrace the basic tenets of the “global growth trade.” Over the next 12-18 months, 50% think inflation is a threat, 41% think the dollar will weaken, and 62% say crude will rise. In 2010, 68% think economic and/or EPS growth will be strongest in the Asia-Pacific region. Nevertheless, optimism for the Materials sector is slipping. In our June 2009 survey, 72% expected outperformance in 2H09 while 2% called for underperformance. In our Sept. 09 survey, just 45% are looking for outperformance in 4Q09 while only 33% think the sector will lead in 2010. In light of declining sentiment for this sector, we reiterate our mid Sept. downgrade to market weight (based on valuation).

Health Care Seen As Less Onerous — Although 33% currently think Health Care will lag in 4Q09 (similar to the sentiment expressed in our June 2009 survey), only 17% think the sector will lag in 2010. 50% of our survey respondents think the sector will market perform in 2010. Additionally, 59% say that Washington will agree on policy reform in 4Q09 or 1Q10, potentially removing a cloud of uncertainty. Though still underweight, we’re intrigued by the sector’s valuations and are keeping this sector on “upgrade watch.”

High Quality Stocks, Small Caps Expected to Lead — Small cap is the most popular choice for leadership in 4Q09 (by 35%) and 2010 (by 36%), as the percent most bullish on mid & micro caps is fading. 62% think “high quality” will start to lead in 4Q09 (23%of those polled) or 1Q10 (by 39%).
Despite double digit gains in the small/mid cap indices since our June survey, valuations are still perceived as attractive by 58%, while EPS surprises are anticipated in the upcoming reporting season by 89%. Over the next 12-18 months, 50% think inflation is a threat, 41% think the dollar will weaken, and 62% say crude will rise...

Who has seen a bear?

Kahneman Says Overconfidence Drives Capitalism

There is an interesting article "Questioning a Chastened Priesthood" at IMF website profiling the psychologist Daniel Kahneman, a winner Nobel Prize in Economics.

Here are some key excerpts:
Delusional optimism, he says, is one of the forces that drive capitalism. Many people don’t understand the risks they are taking, says Kahneman—a theme echoed in a book by Nassim Taleb called The Black Swan (2007), which points out that people fail to take into adequate consideration the possible impact of rare but earth-shattering events that prove wrong their assumptions about the future.
“Entrepreneurs are people who take risks and, by and large, don’t know they are taking them,” he argues. “This happens with mergers and acquisitions, but it also happens at the level of small-scale entrepreneurs. In the United States, a third of small businesses fail within five years, but when you interview those people, they individually think they have between 80 percent and 100 percent chance of success. They just don’t know.”

And here are some takeaways from current crisis:
  • Failure of markets has much wider consequences. “Interestingly enough, it turns out that when uninformed individuals lose their money, it ruins the global economy—so the irrational actions of individuals have much wider effects when combined with the rationality of corrupt agents within the financial system, and very lax regulation and supervision.”
  • Limits of forecasting. “The tremendous volatility in the stock markets and financial system tells us something about the amount of uncertainty in the system and the limits of forecasting.”
Delusional optimism...

Monday, September 28, 2009

J.P.Morgan: Questions, Questions

Analysts at J.P.Morgan have following market views currently:

Portfolio strategy: The jury is out on whether investors have abandoned equities as a long-term asset. We stay long stocks over the remainder of the year.
Economics: Policy makers signal greater focus on asset price inflation.
Fixed income: Move to neutral duration and focus on carry trades.
Equities: Pre-announcements point to another positive surprise for the 3Q reporting season.
Credit: The HY bond default rate is set to collapse to 4% in 2010 vs 9% in 2009. Stay overweight HY credit.
FX: Our main dollar short remains against JPY.

Alternatives: Stay short crude oil, tactically.

And here are some summary replies on selected questions:

Is the crisis over? The financial crisis is largely over. The economic crisis, only half so. The recession is over but the recovery has just started. Even the above-trend growth pace that we project for this recovery will require years to get us back to trend levels of activity. This means high unemployment and disinflationary pressures over the next two years.

Is the recovery sustainable? Yes, odds are it is given unprecedented and synchronized global policy stimulus, low funding costs, a repaired financial system, and the massive need for inventory rebuilding into next year.

What are the main risk factors we should monitor? For the recovery in the world economy and in risky assets to be sustained, the private sector will need to take the baton from the public sector. Corporates are in the driver’s seat here. We need to see them move from a precautionary into an expansionary mode. That means capital spending, jobs, and income creation. Watch these.

Is delevering over? No, to the extent that balance sheet repair and maintenance will remain important objectives of households and companies alike, and soon become so for governments. But delevering is not the first priority anymore. Much of the upcoming balance sheet repair will come from asset price appreciation, allowing economic agents to alter savings and funding practices gradually, without jeopardizing the economic recovery.

Do banks have a lot of skeletons left in their closets, keeping them from fulfilling their credit intermediation role? We do not think so. Our Head of ABS Strategy, Chris Flanagan, estimated last week that global banks and insurers are three-quarters of the way through their cycle writedown and credit losses (US$1.6 trillion so far, versus an estimated total of US$2.25 trillion). He projects that the last quarter of these losses will be spread out over a number of years.

Is it too late to buy equities? No. Both our recovery theme—further upgrading of growth prospects—and our asset reflation theme—the pain of earning no return on
cash while the rally passes you by—keep us long equities.

Click on charts to enlarge, courtesy of J.P.Morgan.

Well, our opinions may differ on many issues.
One should ask, what recovery is sustainable if we still need unprecedented and synchronized global policy stimulus? Why these stimuli?
On banks? I rather think along the lines of "...Speaking Japanese Without Knowing It", by John Hussman today.
Given the large output gap I would question also the capital spending by corporates, also colleagues at competing house of Goldman Sachs think of a Slow Train ...
Also buying of equities tactically may be challenging ... the admired Jeff Saut, the strategist at Raymond James, sounded rather cautious in short-term today, but still bullish for longer run.

Nomura On China's Challenging GDP Maths

Nomura's economists in their "Global Weekly Economic Monitor" address the challenges of China's GDP arithmetic. Paul Sheard in the Global Letter writes:
When the crisis broke in September of last year, policymakers moved quickly and forcefully to kick-start a surge in domestic investment growth. On top of its own big fiscal stimulus package, the central government (in a classic demonstration of how command-economy-style dynamics can sometimes work well) effectively gave local
governments and state-owned enterprises the green light to ramp up investment and gave the banking system the go-ahead to finance it. A credit-fuelled investment boom ensued.

The reason for this relates to China’s challenging GDP arithmetic: an economy that has a very high share of investment in GDP – as a result of investment growth having outpaced GDP growth for a long time – is inherently vulnerable to a collapse in growth when the investment boom stops, as it eventually almost certainly will.

To illustrate, suppose an economy has an investment share of GDP of 50%, investment grows at 20% in a given year, consumption growth is assumed to contribute 5 percentage points to growth and net exports are assumed to detract 5pp: the overall growth rate is 10% per annum. Now suppose investment growth in the next year slows to zero and (unrealistically) the other components of GDP again net out to a zero contribution – the growth rate collapses to zero. If investment were to fall, say by 10% (all else equal), growth would turn negative, to around -5%, with the year-to-year swing in GDP growth being a hefty 15pp. In such a scenario, it is virtually inconceivable that consumption growth could accelerate sufficiently in the short run to offset the downturn in investment. For instance, if private consumption were 35% of GDP, its growth rate would have to accelerate by about 29pp to offset the impact on growth of flat-lining investment growth (43pp in the investment slump case).

Note that, after a prolonged investment boom, even if investment were to fall by 10-20%, let alone just flat-line, having increased for so long and having become such a large chunk of economic output, the absolute level of investment would still be quite high. But the challenging GDP arithmetic implies that even investment taking a well-earned breather in growth could result in a devastating impact on overall growth in such an economy.

Our illustration, while stylised, is not that different from China’s situation. China’s investment share of GDP in 2008 was 43.5% and, according to our forecasts, is set to rise to 49.6% by 2011; the consumption share was 35.3%.
Do not worry, "but policymakers and investors alike should be cognizant of the risks".

Bylov: Global Intermarket Perspectives

Jan Bylov, chief analyst at Nordea Markets, is a "rare specie" among analysts, as he is looking himself at all asset classes and uses inter-market approach in analyzing the markets. He writes in the summary today:

Stocks – Emerging Markets at new highs

World leaders praise domestic consumption to reduce global imbalances and interestingly, the MSCI Emerging Market index is trading at new highs relative to the MSCI World index – an outperformance that has been evident since October 2008 (well seen world leaders)! Anyway, last week’s setback in Western stocks are by several market pundits already called to be the recovery peak, and while the bears might be right evidence appears scarce in our opinion. As we see it most investors have been climbing the wall of worry during the post March recovery meaning that they are underperforming and underexposed and with most economic forecasters expecting improving macro statistics still downside risk appears limited! Further, with yields stable and low, a weak US dollar providing global liquidity, stable commodity prices and leading stock indices still dominated by a sequence of higher lows since March we find it premature to run scared. We are structurally bullish.

Bonds – Encouraging... if anything

Public uproar about ballooning deficits will definitely see politicians focusing on creating a plan on how to get the house back in order, but this is hardly a plan which will become a market moving theme right now. Rather, leading central bankers continue to assure that they will provide amble liquidity and low interest rates for an extended period… to make sure they don’t kill the economic recovery before it ever became sustainable (as Japan did a decade ago). Since summer central bankers have continued their attempt to convince market operators of their very cautious path towards removing the ultra accommodative monetary policies ultimately, and with e.g. German 2-year yields trading at record lows we believe that the pricing of next years’ interest rate hikes could be premature! And judged by the widespread lack of any clear downside price dynamics in Bunds and Treasuries recent price action must be considered encouraging… if anything. Overall, we continue to expect prolonged trading ranges in yields and that the yield direction will be guided by the two transient investment themes: 1) “supply fear and exit strategies” and 2) “high real yields and hesitating central bankers”.

Commodities – Ranging at best

Most commodities are priced in US dollar and consequently, it is important to track the global commodity price performance in all major currencies to get a better grasp of the underlying forces. Now, global commodities haven’t been able to produce and maintain new recovery highs since June! Consequently, global commodities continue to provide signs of stabilising, and this should remove a concern to a continued global economic recovery.

Currencies – JPY soars contrary to forecasters' expectations

With world leaders embracing domestic consumption in surplus countries forces already dominating currencies appear to gain more traction i.e. weak GBP and USD and strong EUR, JPY and select EM currencies (not least Asians). Interestingly, a stronger JPY is clearly not expected according to the consensus forecasts which could trigger more JPY buying within the short term. Now, with BOE and Fed among the most dovish the attack against these currencies continue receiving a tailwind from the news flow, and with market action lacking real evidence of any serious reversals (e.g. clear upside price dynamics in the traded US dollar index) recent currency themes should continue. Valuation considerations do not appear of much interest currently. Consequently, we still favour our May -09 carry basket strategy of long BRL, TRY, RUB funded by CHF and CAD.

And below you find the historic performance of four main asset classes, courtesy of Nordea Markets, click to enlarge.

Saturday, September 26, 2009

Killer Chart By BNP Paribas: Eurozone PMIs (Flash)

BNP Paribas publishes a market economics report "Number Cruncher". This week the nomination of the "Killer Chart" went to Eurozone PMIs (Flash).

The surrounding bullishness implies that the gap will be closed in the coming months by industrial production finally moving to around zero year-on-year growth level.

Click on chart to enlarge, courtesy of BNP Paribas.

However, PMI and year-on-year growth had at least visual correlation in the chart for the past 10 year, or so. It broke down this year ...
PMI survey failed to anticipate the depth of reality? Is it anticipating recovery correctly? Does this make this recession and recovery different?

Friday, September 25, 2009

Quants Highlight Dislocations In Commodities And Equities

Quantitative strategy team at Societe Generale pointed out in their weekly "Top-down QuantSight" report yesterday, that Market Surprise Indices (MSI) highlight dislocations in commodities and equities.

According to their explanations, MSI highlights movements of an asset class that are specific to it and not explainable by another observable market variable. Market surprise signals mispricings and dislocations. It is computed as a normalised average of the absolute value of market-model errors. Surprises over 1.0 / 2.0 have a 16% / 2% probability of occurring.

They go on:

The commodities’ MSI has risen sharply since summer 2009 and currently stands near extreme levels (the likelihood of such situation is less than 5%). In particular, energy prices are more than 50% undervalued on a long-term horizon and livestocks
almost 40% undervalued.

Similarly, equities’ MSI has risen with several equity indices 10% or more overvalued.

Click on chart to enlarge, courtesy of Societe Generale.

Among others, they also have an alert on iTraxx X-Over index and Baltic Dry Index.
Well, I just want to have an understanding, what are inter-market relations and potential consequences for markets.
I started with commodities, oil in particular. I went on for advise at Goldman Sachs today. FT Alphaville features the report too. Well, as the charts below are showing, courtesy of Goldman Sachs, demand in the US has been much lower this year compared to last 4 years ... And inventories have been built on much larger scale, again ...
Of course, the prices have been moving upwards since the beginning of the year, anyway ... although the demand dynamics observable in the real life are still quite sour.

Because the markets are forward looking, and often used as leading indicators, everything is about expectations.

So, everything you need "is just a little patience" ... as "the market has not priced in the economic recovery yet":
This past spring, we also emphasized that the rebound in oil prices from the lows of the first quarter was not driven by an improvement in oil fundamentals, or expectations of improved fundamentals, but was rather due to a normalization of credit markets that allowed the market to arbitrage physical surpluses. This can be seen by looking at the long-dated, or 5-year forward oil price, that has traded mostly sideways for nearly a year, dipping to a low of $65/bbl and reaching a high of $85/bbl ... Consequently, the 2Q2009 rally in prices was driven by a rally in timespreads which came in spite of deteriorating fundamentals. As we emphasize last spring, the driver of this seemingly counter-intuitive dynamic was a normalization in credit fundamentals that allowed the industry to arbitrage physical surpluses at
much lower costs, which tightened timespreads despite no improvement in
fundamentals and created a $25/bbl rally in oil prices.
So, you know now that 5-year forward price is a better indicator of "economic reality", as a payment and delivery in 5 years does represent the "real status of economy" better than prices with delivery and payment tomorrow or in 3 days. It does not matter that you are struggling to meet your payment schedule today, and may be bankrupt in 5 years time ... This fallacy of "implied volatility" in the world of Black-Scholes formula explains us why today is less real than something in 5-years? I leave this issue with Nassim "Black Swan" Taleb.
Finalizing the commodity issue, this should be clear, according to the brokers:
- oil is undervalued, because decrease in demand and build-up of inventories, and also an increase by some 100% since the beginning of the year is not the reality ...
- 5-year forward price is the benchmark.
- market has not priced in the so obvious economic recovery yet!
You don't believe the oil story?

Economic Cycle Research Institute (ECRI) tells us today, that " U.S. Economic Recovery Is "Far From Fragile":

September 25, 2009 (Reuters) - A weekly gauge of future U.S. economic growth climbed higher in the latest week, while its yearly growth rate reached a new all-time high, reaffirming projections of a brisk, uninterrupted recovery.

The Economic Cycle Research Institute, a New York-based independent forecasting group, said its Weekly Leading Index rose to a 60-week high of 127.8 in the week to Sept. 18 from an downwardly revised 126.1 the previous week, which was originally
reported as 126.2.

It was the highest WLI reading since July 25, 2008, when it also stood at 127.8.

The index's yearly growth rate rose to a fresh record high of 24.3 percent from last week's high of 22.9 percent.

Last week, ECRI Managing Director Lakshman Achuthan told Reuters that the group expects an "unstoppable" recovery with "no relevant roadblocks." Fears over mounting unemployment, debt-laden consumers, and dips in recovery are typical of recessionary times, he said.

"With WLI growth climbing to a fresh record high, the economic recovery is far from fragile," Achuthan said onFriday.The index rose in the latest week because of stronger housing activity, ECRI said.

I was watching this video, and discretionary feeling of a "quantitative/statistical arbitrage shop" is not leaving me (around 3:42 minutes of video it is stated clear). Co-Incidental (I stress that again) ... but, quants failed big time in August of 2007. I looked back at mid-October of 2007, when S&P500 reached the peak, and ECRI media activities. Following paragraphs appeared, according to ECRI, at Dow Jones Newswires on 3rd of November, 2007:

ECRI doesn't try to predict stock prices per se, but we can assess stock market risk. This risk is not a constant and really depends on where you are in the business cycle - an issue addressed by the USLLI and WLI.

For over a year dire recession predictions have garnered headlines, despite objective data to the contrary. The fact is that median real home prices, which have been at the epicenter of growth concerns, stopped falling and rose from September 2006 through March of 2007, while GDP rebounded to above trend in the second quarter.

These realities blindsided Wall Street, forcing major houses to slash their 2007 rate cut forecasts last June from a range of 75 to 100 basis points to zero.

For the past half a year, GDP measures show the economy growing solidly above trend. In the third quarter, the same report shows inflation falling to a 44-year low. That was a textbook Goldilocks economy.

Looking ahead, we're facing a broad based slowdown in economic growth, but have plenty of room to slow without slipping into recession. Most importantly, the objective ECRI leading indexes that correctly forecast past recessions - in real-time and without false alarms - remain above past recessionary readings.

Also, it is significant that the Fed has cut 75 basis points in six weeks. While the credit crisis is certainly a major concern, most observers underestimate the extent of receding underlying inflationary pressures. This means the Fed has more leeway to cut rates to alleviate the home price downturn and broader economic slowdown.

These are the nuances of the current U.S. growth rate cycle slowdown. One thing is for sure. The path of the USLLI and WLI will change, and we'll change our tune accordingly, because ECRI's outlook is not based on gut feel, but rather an objective reading of the fundamental drivers of the business cycle. This approach has kept us from being blindsided by recessions for many, many years.

On January 02, 2008 you have this from ECRI, and this on January 17, 2008 ...
So, equities may be already down more than 10+%. Nobody promised to warn you! There is no reason for panic yet ...
P.S. According to ECRI here, January 2, 2008:

One of the pluses of ECRI's Weekly Leading Index is that it's rarely revised, only three times since its inception in 1986.

Achuthan said a lack of revision was a central goal of Geoffrey Moore, former commissioner of the Bureau of Labor Statistics, who established a host of economic series including the WLI and what is now the Conference Board's monthly index of leading economic indicators.

'This index is not optimized, it's not revised and fitted. The weights of components are not optimized in retrospect.' Frequency of the data was another important factor for Moore, who Achuthan said saw the need to make economic data more useful and practical for decision makers in business and government. One of the big advantages of the WLI is that it's weekly and can offer quick reads, and he said perhaps the first read, on whether the economy is firming or slowing.

'Other important factors for an indicator are that it doesn't miss a turn in the economy and it doesn't give you a false signal of a turn in the economy.'

The WLI is based on six components: money supply, JoC-ECRI Industrial Materials Price Index, housing activity, bond market measures, stock prices, and job market measures. ECRI uses a pragmatic mix of indicators for most components, looking at a broad array of measures for example in money supply.

Achuthan said money supply is a big question marks for 2008. 'It jacked up very strong in 2007, at over 11%, and it will be tough maintaining strong growth rates.' Achuthan warned that money supply is often overlooked saying simply, 'The Fed can move the economy through money supply.'

The WLI relies heavily on prices for signals. Prices of course are never revised, which is a plus, and they are the most timely of all data. Stock prices offer what Achuthan
described as 'collective wisdom' on business conditions and profit growth, while the commodity index, which excludes precious metals, offers information on demand in the industrial economy. The level of interest rates of course is a determining factor for future business development with the WLI reading focused on corporate bonds. The exact mix of factors within these categories is proprietary but Achuthan's description points to an exceptional devotion to detail.

Yes, and there are curious cases for the prices ...

Reading Technology Review

Interesting post "The Evolution of Overconfidence" at arXiv blog, this seems to be key:
The puzzle about overconfidence is its ubiquity. Many studies have shown that most people have an exaggerated sense of their own capabilities, an illusion that they have control over uncontrollable events and are invulnerable to risk. Most people, for example, believe they are above-average drivers, a statistical impossibility. We are all overconfident in one way or another.
But it is Johnson and Fowler's predictions that are most worrying. Their model implies that optimal overconfidence increases with the magnitude of uncertainty. So the greater the risk, the more overconfident individuals should become.
Watch out!

James Montier On Patience

I was re-reading the "Postcards from the edge" by James Montier, as I was revisiting the valuation approach used by him. I came to a chapter on patience, from which I wanted to share a couple of paragraphs:
The third aspect of the triumvirate of investment principles to which I try to adhere to is to be patient. This flows naturally from the value approach. As Ben Graham said "undervaluations caused by neglect or prejudice may persist for an inconveniently long time, and the same applies to inflated prices caused by overenthusiasm or artificial stimulants."

One of the curses of following a value approach is that in general I will be too early (both to sell and buy). An example was brought home to me the other day as I followed a link on a webpage to a recommended article that argued hedge funds were enjoying something akin to a bubble. Imagine my disappointment when the link opened a note I wrote in 2004!

Indeed, looking back over my past work being too early is a near constant theme - calling Thailand the next Mexico in 1995, arguing that the equity market was enjoying one last hurrah in 1997 (before losing my head in the mania of the tech bubble), pointing out the bubble characteristics of both the US housing market and commodities in 2005, calling the mining sector a bubble in 2006. Given the propensity for premature warnings I guess it might be better if I wrote notes, and then sat on them for a couple of years before I published them. The alternative solution is, of course, just to be patient.

Sadly patience seems in exceptionally short supply amongst most investors these days. As Keynes noted "compared with their predecessors, modern investors concentrate too much on annual, quarterly or even monthly, valuations of what they hold".

The impatience of some investors can even be a signal that we are nearing the end of the last euphoric stages of a bubble. Hate mail is always welcome from my perspective.
No comment!

Thursday, September 24, 2009

Steroid Soup By Tim Bond For Valuation Pros

FT Alphaville features the latest note by Tim Bond, the head of global asset allocation of Barclays Capital.

I do not focus on the environment that "is ripe for the inflation of asset bubbles" this time. I go for equity market valuations - earnings and PE (price to earnings) ratios in particular.

My eyes were paralyzed by the following chart as valuations appear decent, click to enlarge, courtesy of Barclays Capital.

I have no idea about the "equilibrium PE model" by Barclays that, by the way, serves well for the justification of bubbly valuation in Internet frenzy. However, the path towards lower PE ratios in the next 5 years feels intuitively right.

The problem is that Tim Bond is not specifying his US market, but PE ratios look decent.
Well, let's look at S&P500, where we have access to historical earnings and PE data. Here are S&P 500 Earnings (Operating, As Reported & Core) and Estimate Report, includes Divisors and Aggregates, Core Breakdown, and Dividends. And here are S&P500 historical average price to earnings ratio.

As You open the S&P500 Earnings sheet from Standard & Poor's, the puzzle starts. You get operating, as reported and core earnings. Which one to use? Well, to make the decision, one should have a basic idea of different measures. S&P has a note with explanations here, see Table 2 on page 4 for the main differences between Operating and As Reported earnings.

Credit strategists at BNP Paribas have been wondering:

Over the past equity bubble decade, it has become fashionable for equity analysts to concentrate on Operating earnings as opposed to As Reported earnings, which factor in write-offs and restructuring charges (Charts 1 and 2).

While the difference between the two measures was insignificant until the internet bubble, that difference has grown significantly to the extent that operating earnings look like numbers plucked out of thin air with little resemblance to economic reality. As credit analysts, we are taught that, for a given revenue base, rising costs lower profits, raise leverage and lower creditworthiness. How equity analysts can ignore this fundamental credit analysis is unfathomable to us.

Click on charts, courtesy of BNP Paribas.

Indeed, it looks like Tim Bond is using Operating Earnings for his show, but S&P and credit strategists at BNP Paribas suggest that As Reported earnings are more appropriate. Probably the ignorance of fundamental analysis has been driving us into credit crisis, and still seem to be dominating the equity stage?

Historical data from S&P since 1936 show that average S&P 500 Historical As Reported PE Ratio based on trailing 12-month earnings is almost 16, but the median is 15.5.

12-month forward looking earnings estimates are varying, but let's look at As Reported estimates, that are done by top-down strategists (interestingly, bottom-up estimates are only for operating earnings). 12-month forward estimate is 41.49 USD EPS (earnings per share), which at 1050.78 index closing on my screen tonight makes PE ratio of more than 25. The EPS estimates for full calendar year of 2010 stand at 45.84 USD today, what at current index value makes PE ratio of almost 23.

Well, let' s go bullish to the peak cyclical As Reported earnings in the 2nd quarter of 2007 at 21.88 USD in the quarter, which simply annualizing makes 87.52 USD EPS annualized. At historical average PE of 16 it makes index value of 1400. At the minimum PE of 5.9 recorded in 2nd quarter of 1949 the value would be 516.

In the 2nd quarter of 2009 the As Reported earning were 13.5 USD EPS in the quarter, which simply annualized arrives to the yearly EPS of 54 USD, multiplied by average historical PE of 16 is 864.

For the last 20 years the quarterly As Reported "trend" earnings adjusted for cyclicality are somewhere around 14 to 15 USD, which makes something like 56 to 60 USD of yearly EPS. Multiplied by historical average PE it makes index value of 896 to 960.

One should guess whether massive fiscal stimulus and aggressive monetary policy is justifying above or below average PE ratio. What is the margin of safety or premium to endless next cycle? You decide!

As my old friend says - how many methods of valuation do you know?


The Economist has a view on Baltic meltdown - "Feeling a bit fragile"!
... the gloom may yet last a bit longer.

Bull's Eye Of DBS And Citi, Danske Joins The Party From Nordic Perspective

The Singaporean DBS published its latest "Tactical Regional Asset Allocation" report for Asia ex-Japan yesterday, with a fairly confident tone:
We do not subscribe to W-shaped scenarios for the US or Asia, especially the latter. We have never regarded this downturn as a garden variety recession, rather as “shell-shockarising from the Lehman Brothers debacle and several one-off factors related to China, and have always looked for the sharp rebound that is now underway. And our bet is that the next 10 years will look a lot like the ten that led up to 1997. Faster growth, strong earnings, appreciating currencies and a marked shift towards external deficits.

We stay positive on equities in the fourth quarter. This is despite the fact that the Hong Kong and Chinese markets may experience more volatility. Consolidation, if any, would be a good opportunity to add to positions and we recommend staying invested for longer-term gains. Asia's valuations are getting stretched but support levels suggest a correction would not be severe. Moreover, while Asia is not cheap,
world equity valuations are and Asian stock markets will trade higher with the rest of the world against a backdrop of a synchronized global recovery.

With policy easing having come to an end in Asia, upward
pressure on interest rates is intensifying in most regional markets. Improving global economic conditions and inflation fears give rise to rate hike speculation and Asian yield curves will continue to exhibit a steepening bias in 4Q09. Long-end yields remain more likely to rise than fall in 4Q09 as supply pressures continue to weigh on bond markets. Hence, the outlook for most Asian local currency bond markets remains bearish. Curve flattening is unlikely before rate hikes and we think 4Q09 is too early for this to occur.
Citigroup Global Markets published their "Global Economic Outlook and Strategy" report yesterday too, with little room for concern:
The global economic recovery continues to strengthen. Recent data suggest that the US, Euro Area, Canada, UK and Switzerland are all returning to positive growth in Q3. We continue to make more upgrades than downgrades to our growth forecasts, reflecting the mix of improving financial conditions, the turn in the inventory cycle, major monetary and fiscal stimulus, plus marked improvements in recent surveys and gains in activity data. This month, we are again revising up our growth forecasts for the US and (especially) the euro area, while also significantly revising up our forecasts in Australia, Brazil, Korea, Norway, Poland, Russia, Sweden and Switzerland. Consensus growth forecasts also are rising, but our growth forecasts remain above consensus in most major countries.

With inflation low or absent in most countries, recovery is unlikely to trigger preemptive tightening, and most major central banks will keep rates at ultra-low
levels until growth is solid. We expect the Norges bank and RBA to hike before yearend, but the Fed and PBOC are likely to keep rates on hold to Q2-2010, with the BoJ and ECB on hold for even longer.

This month's GEOS has a theme piece highlighting developments in global imbalances ... Imbalances have diminished markedly as demand has slumped in industrial countries, and we express some cautious optimism that imbalances are unlikely to return any time soon as a threat to global stability.

We also feature latest views from Citi strategists on key asset classes. We are
nervous about prospects for government bond yields and fear that the rising volumes of carry trades in the market is creating a long duration position for the wrong reasons and at the wrong time in the cycle. We remain constructive on equities, credit products and securitised products, but more cautious for many commodities. We expect further weakness in the USD and, especially, sterling. In contrast, we expect further gains by both NOK and SEK against the Euro.
Danske Bank in its Nordic Equity Strategy report also notes today:
Overall we conclude, that the experienced multiple expansion for Nordic companies is not yet critical for the Nordic markets’ ability to perform in the coming months.

A key reason why the Nordic PER is higher than in Europe is a) the
more cyclical nature of Nordic EPS and b) the strong PER expansion in especially Sweden and Denmark. Of the 60% noted above, 93% are cyclicals while 50% of the companies are Swedish and Danish.

We are not taking an overly positive stance on the Nordic market vs.
the European market. However our point is: take care not to view Nordic stocks too negatively. The total inflation in Nordic PER is justified in our view, as we expect strong global expansion and further credit market healing to trigger stronger Nordic earnings
revisions than likely to occur in the broad Pan-European market.
The only reason for concern is not to participate in the risky asset festivities?

Wednesday, September 23, 2009

UBS Is Fitting India Into Asian Growth Profile

The well known house of Swiss "off-shore watchmakers" UBS, is fitting India into the typical Asian growth profile:

There is a typical profile where savings and demographic factors combine to produce a big step-up in average growth. High exports and rapid industrialization are accompanied by other secondary, but common factors such as: low overall indebtedness and maintenance of either a fixed or semi fixed exchange rate, typically to the dollar. All these factors are grouped into the pedagogic chart below. Currently India is still on the left hand side.

Click on chart to enlarge, courtesy of UBS.

Well, in a short summary analysts at UBS believe:

Just two factors tell us India could be waking up to an extended period of high trend growth, we believe, of 8-9%pa: high savings and rising industrialisation. Government intervention matters, but ultimately more intervention just reduces economic efficiency and thereby the step-up in real growth. The basic question is: will real growth centre around 10% pa or sink nearer 5%? The difference between these two boundary rates is the difference between doubling or more than trebling of per capita GDP over a 10-15yr timeframe. As per capita GDP rises from c.$3k today, within the next 1-2years the intensity of spending on investment goods, materials & energy rises almost vertically; then on approach to $10k per head ten years hence consumption spending follows suit. Successive industrialising nations reach these points earlier and India’s no exception. Finally, on structure, whether India continues to run current account deficits or swings to surplus ought not to matter for growth per se. But a deficit path makes growth more volatile because it is vulnerable to: (i) twin external shocks (trade & capital) and (ii) the 'grow-inflate-devalue' pattern due to overemphasis on pro-growth demand stimulation.
I am already knocking at the gates of paradise ...

Danske: Situation In Latvia Just Keeps Getting Worse

Danske pushes the political side this morning:
Yesterday the largest party in the government coalition, the Peoples’ Party, expelled the only member of the party that last week voted in favour of a real estate tax law proposed by the government. Hence, we now have the paradox that the largest governing party expels members that support the government’s own policy. One can hardly blame investors for feeling nervous about the situation in Latvia given recent political developments. Furthermore, the European Commission and the IMF have lost all faith in the Latvian government’s ability to push through with the promised budget measures.
I had a hope that increased traffic intensity is a sign of increased economic activity at the beginning of September. If it was, then it indeed WAS ...

Tuesday, September 22, 2009

Dr. Copper Smacks The Anonymous ECRI Defender ... For Now

Angry defender of ECRI in the curious case of Dr. Copper gets smacked. Thanks to anonymous, I was forced to dig the grave! Still, I should remain reserved, but look for details here or the "Intermarket analysis: profiting from global market relationships" by John J. Murphy, Pages 37 and 38:
The JOC-ECRI Index includes 18 industrial prices grouped into textiles, metals, petroleum products (including crude oil), and miscellaneous products (including plywood). The metals markets include aluminium, copper, lead, tin, zinc, and nickel.
Well, it may be changed now... At least now my assumption is based on historical facts (hopefully)!

This leads me to another round of thoughts ...

Chinese pig farmers "give “the impression that there is strong demand in China,” said Jiang at Shanghai Oriental. “But it is actually those who take a pessimistic view of the economy and are looking to preserve their wealth who are buying.”

This is hardly leading indicator of industrial cycle, and the oil price story is also loosely connected to oil demand in the US. It is no secret that China drives the commodity prices, as the largest consumer in the world ... Further on, China has been mad pressing the accelerator of credit growth so far this year, stockpiling commodities etc. In addition to that, the Chinese renminbi/yuan is pegged to US dollar, and China has been disseminating the weak dollar concern. And one will find quite a correlation between USD and commodity prices...

Does this sound like an industrial growth story for the US?

Paranoid schizophrenia? I am just speculating. Easy riders will save the world ...

Don't underestimate the power of (positive) feedback loops!

Easy Riders, Raging Bulls: How the Sex, Drugs and Rock 'N' Roll Generation Saved The World

Credit strategists at BNP Paribas have published their quarterly credit outlook, the visual design is more than entertaining ... click to enlarge, courtesy of BNP Paribas.

In fact, Easy Riders, Raging Bulls: How the Sex, Drugs and Rock 'N' Roll Generation Saved Hollywood.

China's Potential To Improve The Growth Ponzi-ness

Really nice charts at Nomura. China has a potential to score better in the Ponzi-ness of growth. Click to enlarge, courtesy of Nomura.

India is getting a hefty boost from credit...

Monday, September 21, 2009

My Equity Bullishness

I am even NOT hedged at the very moment, but underweight and with defensive tilt.

This should be considered very carefully, but most likely we may be past the "Discovery" phase and going for the "Slogan", according to Memetics Model by Market Semiotics. Click to enlarge.

The most likely scenario now assumes 4-5% correction, and euphoric buying afterwards. However, last 2 weeks have been more bullish than assumed previously...

Just note, how quickly we came from anomalous realm ...

A Chinese Market That Is Almost Closed

Equity analysts at Societe Generale had a note last Friday on a company that is active in the field of rail equipment. The message on the Chinese hope is as follows (my emphasis):
China has a very large number of rail network development projects and consequently high equipment requirements. However, the group seems to have limited aspirations for the country due to the technology transfer demanded with each contract. Chairman ... observed that China is already self-sufficient as regards infrastructure works, would soon be so in terms of rolling stock (including high speed trains), and would also be able to do its own signalling within five years.
Remember the LCD manufacturing policy?

Unleashing Chinese Consumer

Sell side is running hot with Chinese consumer investment theme. McKinsey wrote in the report recently:
There is recognition at the highest political level in China that the economic paradigm that has served the People’s Republic so well thus far is no longer fit-for purpose. China’s investment-led model has skewed the economy toward industry and has made corporate investment too cheap, leading to inefficient investment in excess capacity. Reliance on exports has left China exposed to a downturn in its major markets. As the global fallout of the US financial crisis has put new strain on China’s current development model, the case for shifting toward a stronger reliance on domestic consumer spending has gathered force.
While searching for the reference to my sadly curios Dr. Copper story, I came to a quite old story written by Stephen Roach back in March 2006:
The Chinese leadership is going out of its way to inform its own citizens, as well as those in the broader global economy, that it will now push for just such a rebalancing. That was certainly the major thrust of the recently approved 11th Five-Year Plan...
The second leg of the stool is the government’s pronouncement on the intent to rebalance the mix of GDP growth over the next five years. Ma Kai, Chairman of the National Development and Reform Commission, did the heavy lifting on this point — stressing the need to boost both the consumption and the services shares of Chinese GDP at the cost of lowering the portions going to exports and fixed investment.
The Chinese consumer will not spring to life over night. But this is likely to be a major story over the next 3-5 years.
More than 3 years are gone ... and the debate is heating up - what springs to life?

Dr. Copper Revisited ...

While posting on the latest release by ECRI on US WLI, I started with a curious story on Dr. Copper last Friday. Somebody asserts that ECRI is not using copper prices as a leading indicator, and I have to admit that I may be indeed wrong, as it was mere assumption derived from the fact that ECRI uses "Commodity prices" as a component of leading indicator ...

I was thinking of "Dr. Copper" in the context of this story by Stephen Roach at Morgan Stanley:
Barton Biggs always used to chide me that “Dr. Copper” was his favorite economist -- possessing an uncanny knack to provide a real-time assessment of the state of the global economy. I suspect that the good doctor has now taken his or her finger off the pulse of the real economy and spends far more time looking at Bloomberg screens. Pity the poor patient -- to say nothing of the doctor!
It would be great to see inside the ECRI WLI!

Bylov: Global Intermarket Perspectives

Jan Bylov, chief analyst at Nordea Markets, is a "rare specie" among analysts, as he is looking himself at all asset classes and uses inter-market approach in analyzing the markets. He writes in the summary today:

Stocks – Surprises remain generally on the upside

Humans fear pain more than we appreciate the same dose of gain, and this characteristic plays an important role in why investors “climb the wall of worry” during the most part of a bull market! Sentiment surveys, futures traders’ positioning and the usual gang of prominent names calling for Armageddon continue to provide evidence advocating that investors are concerned about the future and that “the recovery just cannot be true”. Such worries may or may not be right ultimately but with yields stable and low, a weak US dollar providing global liquidity, stable commodity prices and rising stock prices the current valuations don’t appear bubble-like! Further, with no real deterioration in the market action within leading Western stock markets we still believe that a new hostile market theme has to surface to produce a real threat to a continuation of the 2009 global stock market recovery. We remain structurally bullish.

Bonds – Will central bankers risk a Japan scenario?

Undoubtedly, central bankers feel caught between the improving evidence of recovery and the risk of reversing the dovish monetary policies too early killing off the recovery before it ever became sustainable (and thereby committing the same mistake Japan did a decade ago). Now, aside from market rumours and blurred comments from central bankers we find it unwise to neglect the message from e.g. German 2-year yields trading at record lows. Such record lows appear to suggest two market perceptions: a) increasingly investors realise that leading central banks are in no rush to implement exit strategies and b) investors hold no strong belief in the post March 2009 global recovery in asset prices and macro statistics. This warns against becoming aggressive in betting on the implementation of the famous exit-strategies! Bunds remain more ranging than trending which continues to caution being optimistic with momentum trading – and not least with central bankers talking so cautiously. Overall, we continue to expect prolonged trading ranges in yields and that the yield direction will be guided by the two transient investment themes: 1) “supply fear and exit strategies” and 2) “high real yields and hesitating central bankers”.

Commodities – No new recovery highs

The US dollar is under siege but interestingly, commodities are not producing new recovery highs measured in USD and certainly not when measured in EUR and JPY. Further, industrial metals have begun underperforming precious metals, and oil is remarkable stable below recent months’ high at $75. Consequently, global commodities continue to show signs of stabilising, and this should remove a concern to a continued global economic recovery.

Currencies – Public finances and exit-strategies

The full-blown US dollar attack continues and with Sterling under hefty pressure it appears that investors are abandoning currencies characterised by uproar on public finances and central banks whose statements regarding exit-strategies appear the most dovish. Further, investors seem to question that Fed wishes to cut back on the global USD liquidity with a still recovering economy. Additionally, rising stocks, stable commodities and ranging bond yields continue to resemble a shadow of the old Goldilocks scenario advocating that cyclical bets still hold the upper hand. As a consequence, we remain structurally optimistic/bullish on the global recovery and we still favour our May -09 carry basket strategy of long BRL, TRY, RUB funded by CHF and CAD.

There are less bears remaining in the field. This should be the real new world where equities markets see the upside surprise, but bond market cannot get rid of "Japanese syndrome".