What is CAPE? — Benjamin Graham, who taught Warren Buffet at Columbia Business School, argued that one should use average profit over a number of years in calculating PER. Based on this, Yale professor Dr. Robert Shiller uses average profits over ten years in calculating the PER for the S&P 500. The ten year average more or less factors out economic impact, so today we refer to the measure as cyclically adjusted PER (or CAPE).Click on charts, courtesy of Citigroup Global Markets.
Fed delivering on firmer growth and higher inflation
Our panel of 287 institutional investors enter the New Year optimistic on growth and bullish on equities. The firm hand of the Fed is evident in inflation expectations rising sharply but with no imminent rate increase expected, investors see few alternatives than to stay with risk assets. The level of equity enthusiasm and relatively low cash levels signal some concern but there is to us little evidence of over-exuberance in the survey. The risk to a bullish consensus is if US growth expectations are de-railed by either weaker data or tighter policy. This suggests time for portfolio protection & diversification rather than out and out selling.
Inflation view at 6-year high
Global economic optimism is back to the highs of Apr-10, helped by monetary policy which is seen as the most expansionary since Jul-04. A net 72% expect higher inflation in the next 12m, the highest in almost 6 years, and yet views on the first Fed rate rise continue to be pushed back well into 2012. Risk appetite is strong (risk composite 46 vs. a long term avg 40) but contained with average cash holdings rising slightly to 3.7% and hedge funds reigning back equity exposure.
Loose money, pro-growth; allocation straightforward
A net 55% of asset allocators are O/W equities, the highest reading since Jul-07. With the lowest bond weighting, net 54% U/W, since Aug-07 and a cash U/W of net 5% investors have little cushion against any growth disappointment.
Signs of life in developed markets
Investors are the most positive on US equities (+27% O/W) since late-08. Japan at +5% O/W is also benefiting from not being Europe which allocators cut to a net 9% U/W, a 6-month low. EM remains the most favoured region (net 43% O/W) but this is sharply down on +56% seen in Nov-10 as profit hopes for GEM continue to fall back. Despite economic growth optimism, views on corporate profit outlook moderated in January with a net 50% expecting improvement vs. 51% in Dec.
Cyclical rotation and (very) selective bank improvement
Investors want to retain a cyclical tilt but are prepared to rotate portfolio exposure: tech (+39%) and industrials (+17%) benefit this month at the expense of materials (cut to net 20% O/W from +28%). Banks had the biggest rise in sector positioning, to a net 21% U/W (from -28% in Dec) but it remains a deeply unloved sector with Japan the only region showing improvement. Tech regained most favoured sector status and alongside energy (+36%) are the two high conviction sector trades.
Contrarian trades
For the contrarian: short equities, long bonds; short US, long Europe; short tech and energy, long banks and utilities.
Spain's Treasury issued 5.5 billion euros ($7.34 billion) of 12- and 18-month T-bills on Tuesday, in the middle of the targeted range and with both issues at a lower yield than the previous auction in December.However, the rate strategists at Nomura are posing some questions about Spanish issuance policy:
The debt sale was the first time this year the Treasury has taken its short-term paper to the markets.
An auction of 5-year bonds Jan. 13 went better than expected, helping boost sentiment toward the euro zone's peripheral economies. ...
One of the key innovations the Spanish Treasury introduced for 2011 is its monthly publication of the list of references to be auctioned, rather than its previous quarterly updates. This was done with an aim “to provide the Treasury with greater flexibility when it comes to adapting its issuance to market preferences in a very volatile environment” (see link). Yesterday’s decision to cancel the Oct 20 and Jan 24 taps, which were announced last Friday in favour of syndication of a new 10yr benchmark perhaps brings into question the transparency. The syndication proceeded well, with the Treasury able to place a larger than expected €6bn. However, pricing terms were very cheap (taking the market lower) and if the experience of issuers in 2010 is any guide, this is not necessarily a great set-up for digestion. Meanwhile, such a rapid about-face suggests either an element of desperation or a communication policy gone badly wrong.Add to the fundamental background the QOTD: On the Real Economy, German ZEW, Shanghai Composite, and look at bullish break-out of European bastard child:
Policies have contributed to a stronger stock market, just as they did in March of 09 when we did the last iteration of this. The S&P is up 20% plus and the Russell, which is small cap stocks, is up 30%, so I think a stronger economy helps small businesses more than it helps large businesses.
So far, the commodity rally has been absorbed quite well by the US economy and we do not yet see the commodity price shock as strong enough to derail the recovery. However, it is a growing risk that could start to squeeze profit margins. If prices continue to rise at the current pace, the recovery could be threatened.Sure, also in the unfortunate case the US administration will find a solution, like another round of fiscal and monetary stimulus for the benefit of bond vigilantes ... so that China can finally collapse and pull the rest of the world into deflationary spiral?
A few more successes and the European periphery will be destroyed.Interestingly, cream lickers at efficient frontiers do not bother about relativity of Chinese, Japanese and German apparent prosperity. You just add the fiction that banks are private enterprises, and the animal spirits are set free. EuroStoxx Banks Index added only 7.28% today, spreading the panic among squeezed shorts ...
Bullish at a lower price. Investors seem nervous about buying our Buys after the rally the sector has had (e.g. BKX up 19% vs. SPX up 7% since Nov 26 relative low). That said, investors seem equally nervous about selling our sells given steadily rising GDP estimates (e.g. 4Q consensus GDP estimate has risen from 2.4% to 3.5% over the same period).Click on chart to enlarge, courtesy of Nomura.
Long horizons, equally long memories. Bank bulls are looking at a cyclical sector with below-average valuation amidst economic improvement. However, they also remember the pattern of banks rallying into earnings, peaking when JPM reports, and selling off thereafter.
... most people don't know what they want unless they see it in context. We don't know what kind of racing bike we want - until we see a champ in the Tour de France ratcheting the gears on a particular model.
RELATIVITY IS (RELATIVELY) easy to understand. But there's one aspect of relativity that consistently trips us up. It's this: we not only tend to compare things with one another but also tend to focus on comparing things that are easily comparable - and avoid comparing things that cannot be compared easily.I see also this relatively ... bullying cognitive dissonance.
... the more we have, the more we want. And the only cure is to break the cycle of relativity.
Meanwhile, while the discussion over foreign US funding risks remains hot, US credit default spreads have been stable. Sure, US foreign held assets are substantial, but of the USD 8trn of foreign liabilities, more than half are held by foreign central banks. Official accounts are unlikely to move these assets out of the USD unless there is a credible alternative as a reserve currency. The EUR has failed the test for now with its peripheral debt and competitiveness problems and the RMB is not yet fully convertible. The lack of alternatives will keep the USD in place as a reserve currency, buying the US authorities time to get their fiscal house in order. If there was be an alternative reserve currency on hand now, the USD would be much more vulnerable to a funding crisis. In this sense, bad news from EMU and China going slow in making the RMB fully convertible is good news for the US. Chart 2 shows that the US CDS spread has moved less compared to the GDPweighted EMU CDS spread, despite the eurozone running at an aggregate level lower private and public debt levels than the US. The muted reaction of the US CDS to ballooning US deficits is related to the USD’s still-unchallenged status as a reserve currency.Click on charts to enlarge, courtesy of BNP Paribas.
