The magnificent 7 and equity markets - Review 11

Since I last wrote about the magnificent 7 in February 2011, a lot has happened and it is rather appropriate to review where do we stand at the beginning of 2012.

Despite all discussions about recession/double dip in the US for most of 2011, it did not occur and growth looks to carry on, whilst at a moderate pace; this is strikingly different from what we have been witnessing in Europe since the summer and the inability of European policy makers to put the eurozone (“EZ”) house in order.

In 2011, the DJ increased 5.5% (the S&P 500 was flat) which is not so bad given what happened in the world, and in Europe in particular. If one picked up dividend aristocrats it was a reasonable year in the US.

 In Februray 2011 I wrote: “Economic news from the US continue to point towards a continued GDP growth and a (slowly) improving situation in unemployment; Commercial and Industrial Loans at All Commercial Banks in the US have definitely passed the trough and now seems to be well entrenched in an upward move”.  . The latter indicator has displayed the 12^th positive number in a row for a total of USD +114 bn (USD -411 bn during the 25 months starting in November 2008) and this points towards a continued growth in the US 6 months ahead.

Friday’s employment numbers were rather positive at +200k bringing the unemployment rate down to 8.5%.

Things indeed went in the right direction and 2012 starts under the same auspice bearing that:

• The FED continues with its low interest rate policy along the yield curve, which is most likely during a Presidential election year and in the current economic environment.
• International investors continue to buy the US debt, which they should in my opinion by the lack of other choice, continuing to believe that the US will tackle one for all its deficit and inflation will be kept in check. 

In Europe, the picture is getting worse by the month, even the German engine is slowing down markedly. There are more and more voices calling for custom tariffs to fend off imports from low costs producing countries and added regulation: Europe has been naïve with its strong euro policy (well, it was Germany’s call to get the euro) and is battling the last war with increasing regulation, taxation and bureaucracy. Until the EZ sorts out its mess (both banks and over indebted countries) growth will be sub-par. This being said, like in the US, there are world class companies, which are more affected by what happens in the fast developing world, and very profitable niche players that we like to find at P&C.

Fast growing economies in the rest of the world keeps up forging ahead whilst inflation continues to be a real issue (food prices remain very high in China and India, albeit going down recently). However, this is more a consequence of a growing population and a faster developing middle class: a strong engine to growth. In addition, some countries like India are going 2 steps forward and one backwards in terms of liberalization of their markets (for example opening up the country to foreign supermarket companies). 

The graph below is self-explaining…

S&P 500 Banks index: for over two years, the index has traded range bound and has yet to decisively to breach the 165 level; there is no sign this happening any time soon and, conversely, there is no sign of a deterioration either, US banks continuing to recapitalize thanks to an unabated FED QE. In my opinion, the level comes from a continuing reappraisal of the future profitability of banks (less leverage + more controls = lower ROE) versus their ability to pass on additional costs to customers. Neutral.

Global 1200 financial index: The index broke its 200 MA in May 2011 and several support levels, reflecting the deepening crisis in the EZ and the need to recapitalize European banks beyond the official numbers (not talking about OTC derivatives where nobody knows what the global risk is, even banks on an individual basis probably do not know their real risk); the solid 800 floor was penetrated without a whisper and now represents a resistance. The outlook for a number of Europeans banks is bleak and the introduction of Basle III rules ahead of the 2019 deadline is adding pressure. Negative.

TED spread (LIBOR USD 3 mth - US 3 mth T-bills): since July, the spread has deteriorated but in an orderly manner (the OIS displays the same pattern) and is nowhere near the 2008 crisis levels, with central banks reacting very quickly by opening USD swap lines and the ECB offering 3 years lines of credit (LTRO) in the tune of EUR 426 bn. Neutral

USD bank BBB 10 yr - US 10 yr yield: In July the spread started to widen markedly, whilst well below the extraordinary stress of 2008-2009, to pause for the past 2 months. Neutral.

OEX volatility: OEX volatility had a spike during the summer but did not break the high of 2010 and has since come back to the low 20s. Positive.

S&P Case Shiller house price index: The latest data for US home values (October) published 27^th December have continued to go down for the 5^th consecutive month, only two cities showing positive numbers.

The unadjusted data are negative (-4% since July, the recent high); adjusted data display the same pattern:

Composite-10: Oct 2011: m/m -1.1%; y/y -3.0%

Composite-20: Oct 2011: m/m -1.2%; y/y -3.4%

As the report comments:

“Some of the other housing statistics posted relatively healthy figures for November, but it seems that most of the good news was confined to the multi-family sector. Existing home sales rose in November, but are still at a low annual rate of about 4.0 million. Single family housing starts also rose, but remain close to record lows and are still down about 1.5% versus October 2010.”

The recovery did not materialize. Negative.

Oil price: The WTI oil reached a peak of $115 to settle down in a $80 - $110 range. In 2011, the story was he spread between the WTI and Brent which reached $25 in August reflecting the glut of crude at refineries in the US and the Arab world revolutions with oil disruptions in Libya. In the US, unconventional oil & gas recovery is a game changer which explains low prices for natural gas at below $4/btu: Neutral.

Conclusion: The indicators on the banking situation deteriorated, whilst other indicators are mostly neutral. The macro-economic situation between Europe and the US is diverging to the advantage of the latter, even if in both cases public finances are in disarray. The magnificent 7 are telling us that nibbling equity markets will provide an interesting return.

2011 was bumpy and 2012 will be no less hectic.

Continue investing in high yielding equities / net cash companies with a strong franchise and look at strong brands in fast growing economies.

09/01/2011

 

Sources:

Markets & Beyond: The magnificent 7 and equity markets - Review 10

http://marketsandbeyond.blogspot.com/2011/02/magnificent-7-and-equity-markets-review.html

US Department of the Treasury: Monitoring the economy

http://www.treasury.gov/resource-center/data-chart-center/monitoring-the-economy/Documents/monthly%20ECONOMIC%20DATA%20TABLES.pdf

S&P/Case-Shiller Home Price Indices

http://www.standardandpoors.com/servlet/BlobServer?blobheadername3=MDT-Type&blobcol=urldocumentfile&blobtable=SPComSecureDocument&blobheadervalue2=inline%3B+filename%3Ddownload.pdf&blobheadername2=Content-Disposition&blobheadervalue1=application%2Fpdf&blobkey=id&blobheadername1=content-type&blobwhere=1245326665736&blobheadervalue3=abinary%3B+charset%3DUTF-8&blobnocache=true

Markit (via Business Insiders): Manufacturing PMI indices by country

http://www.businessinsider.com/chart-of-the-day-manufacturing-pmis-january-2011-vs-december-2011-2012-1?nr_email_referer=1&utm_source=Triggermail&utm_medium=email&utm_term=Money%20Game%20Chart%20Of%20The%20Day&utm_campaign=Moneygame_COTD_010312

The magnificent 7 and equity markets - Review 10

I have not written about the magnificent 7 for a couple of months and it is rather appropriate to review them following the strong performance displayed by equity markets around the world since then.

In September I wrote: “I have not changed my view of no double dip and the FED QE2 (USD 1 trillion dollar additional liquidity) if confirmed will fuel asset prices. […]The S&P500 … has yet to pass the 1200 mark again which I expect to be done by the end of the year”. Since September, the S&P 500 went up 20% (including last week correction). Late October the market started to accelerate and became overextended; events in the Arab world have triggered an overdue correction.

Economic news from the US continue to point towards a continued GDP growth and a (slowly) improving situation in unemployment; Commercial and Industrial Loans at All Commercial Banks in the US have definitely passed the trough and now seems to be well entrenched in an upward move: it shows that banks are again net lenders to the economy (+ USD 13.7 billion in two months – for other economic indicators please refer to http://marketsandbeyond.blogspot.com/2011/02/us-economy-outlook.html). In Europe Germany is almost exclusively the only growth engine with a rapidly improving economy on the back of strong exports and an improving domestic consumption. Fast growing economies in the rest of the world continue to forge ahead whilst inflation is becoming a real issue and will put pressure on Central Banks/Governments to act sooner rather than later; this is reflecting in stock markets (+/- 10% down).

S&P 500 Banks index: the index has traded range bound for 18 months and has yet to decisively to breach the 165 level; there is no sign this happening any time soon and, conversely, there is no sign of a deterioration either. In my opinion, the level comes from a continuing reappraisal of the future profitability of banks (less leverage more controls) versus their ability to pass on additional costs to customers. Positive.

Global 1200 financial index: Since July 2009, the world financial is trapped within a 20% range, 800 representing a solid floor and 1000 a ceiling difficult to decisively pass. Reasons for this are equivalent to the US: new domestic/regional rules and new BIS capital ratios. However, in Asia, banks are slightly under pressure due to persisting questions about the magnitude of non-performing loans in China in a booming economic environment which is spurring inflation, whilst in Europe fears about the health of Eurozone banks regularly comes back to the forefront together with problems with PIGS countries. The index continues trading around its 200 days moving average. Positive.

TED spread (LIBOR USD 3 mth - US 3 mth T-bills): the spread continues to stand well below its 20 years average (the OIS displays the same pattern whilst has started to pick up since December reflecting persistent question marks about the quality of European banks’ assets) . The interbank market shows no stress. Positive.

USD bank BBB 10 yr - US 10 yr yield: After posing for a coupe of months, the spread started to march downwards again in November. Positive.

OEX volatility: OEX volatility continued to regress to break the 20% level, recently checked by events in North Africa and the Middle East. Neutral.

S&P Case Shiller house price index: The latest data for US home values (December) published 22^nd February have continued to go down for the 5^th consecutive month, only two cities showing positive numbers.

The unadjusted data are negative (-4% since July, the recent high) - adjusted data post the same pattern:

Composite-10: Dec 2010: m/m -0.85%; y/y -1.20%

Composite-20: July 2010: m/m -0.96%; y/y -2.38%

As the report comments:

“We ended 2010 with a weak report. The National Index is down 4.1% from the fourth quarter of 2009 and 18 of 20 cities are down over the last 12 months. Both monthly Composites and the National Index are moving closer to their 2009 troughs.”

The slow recovery faltered. Negative.

Oil price: The oil prices broke through $ 90/b to trade at $ 112 for the Brent and $98 WTI. The situation in the Arab world compounded already rising oil prices. Events in Libya (1.6 million b/day production, now shut down) escalated fears in the market even if there is no penury expectation due to spare capacity within OPEC that would come on-stream if needed (+/-3 million b/day). However, continued unrest in the region and a real possibility of this spreading to Gulf producing states, including Saudi Arabia, will continue to maintain high prices: this will act as a tax on growth; for the past 40 years, all recessions had oil prices spiking beforehand. In the US natural gas prices traded well below $4/btu until Friday when prices passed the $4 mark; still, they remain at depressed levels thanks to shale gas. Uranium jumped 50% to $65 since our last review late September. Half-way has been walked to the June 2007 at $138: Negative.

Conclusion: The indicators on the banking situation remain significantly positive, the rest definitely turned down. Equity markets are correcting (overdue since the divergence with the 200 days MA was getting overstretched); the risk is that this correction gathers pace due to higher oil prices and inflationary pressure already significant in fast growing economies (and starting to appear in the Western world) leading to monetary tightening. The magnificent 7 are telling us that it is time to reduce exposure to equity markets in fast growing economies and high beta stocks elsewhere.

Continue investing in high yielding equities / net cash companies with a strong franchise. Opportunities will soon come up in emerging markets.

Sources:

S&P/Case-Shiller Home Price Indices

http://www.standardandpoors.com/indices/sp-case-shiller-home-price-indices/en/eu/?indexId=spusa-cashpidff--p-us----

Winners & Losers in 2010

Source:

Bloomberg via Saxo Bank

Chart of the Day: Stock market rallies since 1900

Chart of the Day had an interesting chart showing the length of bull markets; as they commented:

the current Dow rally (hollow blue dot labeled you are here) is still somewhat short in duration and below average in magnitude when compared to all the stock market rallies that occurred since 1900

Chart of the Day adds:

Most major rallies (73%) resulted in a gain of between 30% and 150% and lasted between 200 and 800 trading days.

Whatever the imperfection of such data (where are the rallies in bear markets, that can be extremely profitable), this a useful reminder that the current bull market (or rally in a bear market) is not yet de end if history repeats itself.

Source:
Chart of the Day: http://www.chartoftheday.com/20101105.htm?T

Economy and equity markets: are they disconnected?

saSince July 2009 I have been ambivalent with equity markets after their strong recovery from March low and continued weak economic data. The magnificent 7 indicators are all favorable and therefore tell us that there is nothing to panic about equity markets. But is this disconnected from the economic reality? So, let’s review a number of economic indicators. More than the numbers themselves, I will be looking at trends. In this analysis, I will neither review the situation of the financial sector nor the housing sector.

1. GDP breakdown

The second estimate of the fourth-quarter increase in real GDP is 0.2% higher than the advance estimate at 5.9% annualized, primarily reflected upward revisions to private inventory investment, exports and nonresidential fixed investment that were partly offset by an upward revision to imports and downward revisions to personal consumption expenditures and to state and local government spending.

The trend is definitely improving. The next 2 quarters will tell us whether we may get into a second dip recession. Today, I tend to give the GDP the benefit of the doubt.

The Conference Board Leading Economic Index increased 0.1% in February (+0.3% in January and +1.2% in December) pointing to a slow recovery, but a recovery nonetheless.
Ken Goldstein, Economist at The Conference Board: "The indicators point to a slow recovery this summer. Going forward, the big question remains the strength of demand. Without increased consumer demand, job growth will likely be minimal over the next few months."

2. Consumption

Personal disposable income has grown for 5 month in a row until it decreased in January due to an increase in federal non-withheld income taxes according to the Bureau of Economic Analysis. At the same time, the personal consumption expenditures went up for the 9th consecutive month in January (+ $52.4 billion). The personal saving rate decreased to 3.3% from 4.2% in December, but is now in solid favorable territory, even if I would like to eventually see it in the 7-8% region.

The trend is positive. In my opinion, pay checks given by the Bush and Obama administrations were used to repair households’ balance sheets during H1 2009, and now we are witnessing a non-subsidized consumption growth.

Household debt service payments and household financial obligations as a percent of disposable personal income have also decreased from 13.92% and 18.87% in Q1 2008 to 12.60% and 17.51% in Q4 2009 respectively.

All this translated into an improving picture for retail sales.

3. Unemployment

Unemployment seems to have stabilized with an unemployment rate of 9.7% in February and 14.9 million unemployed; the number increases to 16.2% and 24.9 million unemployed if we add part-time workers for economic reasons and discouraged workers, but slightly off the high reached a coupe of months ago. However, the number of discouraged workers continues to increase unabated to 1.2 million people (+65% compared to February 2009 and + 13% compared to January 2010) .

The employment situation, according to the establishment data, confirms this stabilization. Total non-farm employment went down 36,000 in February vs. -26,000 in January, -726,000 in February 2009 and -109,000 in December. Weekly hours worked also point toward a stabilization.

The diffusion index for the total private sector dramatically improved to 48.0 in February vs. 44.2 in January, 39.6 in December and 17.1 in February 2009 (50 percent indicates an equal balance between industries with increasing and decreasing employment). The diffusion index for manufacturing jumped to 54.9 in February vs. 40.9 a month earlier.

4. Banks’ lending

In February, banks continued to shrink commercial loans for the 16th month in a row, shedding an additional $17 billion; total commercial loans outstanding are back to the summer 2007 and $345 billion below the peak reached in October 2008 ($1,645.6 billion).

Whilst this is negative for growth as a whole since less credit is available, I take it as a favorable element in what was an economy built on over-indebtedness steroids, particularly at the household level, and the system has to be purged.

In addition, the rate of decline seems to be arriving at or near a trough.

5. Net export of goods and services

The balance of net export of goods and services dramatically improved, whilst higher again for the last two quarters, to represent a $449 billion deficit. This suggests that the US trade deficit will have a long way to really get any closer to being balance.

As soon as the economy will improve on a sustainable basis, energy and commodities prices will forge ahead and will add more weigh on the US trade balance. Any oil alternative like gas or shale gas, will take some time to gap the national output/consumption imbalance, but worth watching since it could change the ball game.

Conclusion

Equity markets have anticipated the economic recovery which is in its infancy. The important indicators are at worse stabilizing. Markets paused in July and again in January/February to go back to their previous high and extend to new post crisis highs.

As of today, market patterns are justified by economic data. However, on a simple valuation based on Shiller’s cyclically adjusted PER, the S&P 500 is becoming expensive at 21.3 x earnings on March 18 vs. 13.3 x in April 2009 and an average of 16.4 x. On a simple PER basis, the S&P 500 is trading at the top of its mid 30s - mid 90s range but well below its mid 90s – 2008 exuberance.

I conclude that equity markets are not disconnected from the real economy and there no reason, under the current circumstances, to fear a market collapse. The S&P is however no longer cheap and, despite a good earning season, I would continue to selectively buy on weakness quality stocks having displayed their ability to pay dividends. I would favor energy (oil in particular), technology and consumer companies with worldwide brands (P&G, Nestlé, Unilever, J&J for example) as well as “progressing” markets (terminology that I prefer to emerging) and stay wary of bank’s stock at least in the "regressing" world (i.e. developed).

Monetary policy will remain accommodative until the real estate market has fully recovered and don't forget, “never fight the FED”. As my friend, Jacques-Henri Gaulard, Managing Partner of Autonomous Research – a top notch independent research firm specializing on the financial sector -, says about interest rates : "we have moved from L4L to L4E – Low for Longer to Low for Ever…"

Sources:

Bureau of Economic Analysis: National Economic Accounts

http://www.bea.gov/newsreleases/national/gdp/2010/txt/gdp4q09_2nd.txt

The Conference Board: Global Business Cycle Indicators

http://www.conference-board.org/pdf_free/economics/bci/birdairc2.pdf

Bureau of Labor Statistics: Employment Situation

http://www.bls.gov/news.release/empsit.toc.htm

Federal Reserve Bank of St Louis: Economic Research

http://www.research.stlouisfed.org/

Yale Department of Economics: Robert Shiller Online data

http://www.econ.yale.edu/~shiller/data.htm

FullerMoney: S&P 500 Graph

http://www.fullermoney.com

Markets & Beyond: The Magnificent 7 and Equity Markets

http://marketsandbeyond.blogspot.com/2010/03/magnificient-7-and-equity-markets.html

Autonomous Research

http://www.autonomous-research.com/x/default.html

Chart of the Day: Stock market rallies

Chart Of The Day The published an interesting chart providing some historical perspective to stock market rallies.

The current Dow rally that began just over one year ago can be classified as both short in duration and below average in magnitude: most major rallies (73%) resulted in a gain of between 30% and 150% and lasted between 200 and 800 trading days has entered the low range of a "typical" rally and would currently.

The question often asked is whether this is a bull rally in a bear trend or a secular bull market. The definition a bear market is probably more important: in my opinion, and I agree with David Fuller, it is a contraction in valuations; this contraction does not mean that the stock market must fall, it may just trade in a range for an extended period of time or grow very slowly, and well-below historical average.

Source:

Chart Of The Day : Stock Market Rallies (Dow since 1900)

http://www.chartoftheday.com/20100319.htm?T