Recently a friend picked my brain on a few of the prevalent issues of the day that are plaguing most capital market traders (at least one would hope they would be bothered by these issues). These are merely only passing thoughts – at the very least please use them as a guide in shaping your own philosophy pertaining to the future direction of the markets…
[Asked a general question about the broad maco-economic ‘picture’]
My general view is that we are in the midst of a "U" shaped recovery that usually follows a post debt bubble, credit-contraction induced recession. It is my view that the 2007-2009 recession is unlike any recession post WWII and therefore should be compared to the depression era of the 1930's and of selected decades in the 1800's. What we are dealing with now is a generational shift (boomers retiring) and a fundamental reshaping of our societies' appetite for debt and savings.
[Bottom line: do you believe the bottom is falling out and the market is going to go much, much lower?]
Odds of a deeper correction remain elevated: market is somewhat over-valued and not over-sold:
Consensus 2011 S&P 500 EPS estimate ($96.00) – at a 12x multiple this gives a fair value of the S&P at 1152. However, this general EPS estimate is based on the premise that sales growth will be robust and profit margins will expand or at least remain stable. Presently, S&P 500 profit margins remain near an all-time high and are likely an anomaly caused by one-time events related to inventory liquidation. Also leading indicators are flattening out and in the case of the ECRI leading index are actually toppling over. The ECRI leading growth index recently crossed below -10%, which in its over 30 year history has always signaled an ensuing recession (However I’m not convinced yet that the odds of a double dip are 100% as this indicator may be skewed by recent statistical volatility). If we assume that sales (as a function of GDP growth) remain at best stagnant (say H2 2010 GDP growth of below 1.5%) and that profit margins weaken, we can safely say that 2010 and 2011 EPS targets will not hold on the upside (ie. earnings will shock to the downside). In other words, 2011 earnings of $80 per share seems a more likely scenario. This would justify an S&P500 fair value of 960. (PE ratio of 12 times $80 2011 EPS). Of course maybe something far worse develops and the global economy goes down in a deflationary tailspin (or far better?).
Technical picture of the S&P500: momentum and breadth (% of index components above 50 day moving averages) indicators are not generating buy signals. Also, investor sentiment is to some extent pessimistic but certainly not excessively bearish. Ideally you would want to buy into the equity markets when negative emotions are ruling the day.
[Do you see deflation for the near and mid-term as the primary worry?]
Near & Mid-term: low inflation or deflation
2+ years: possibility of moderate/high inflation as the velocity of money recovers
A finance professor once defined for my class what deflation is: “Too few dollars chasing too many goods and services”. To me the convergence of continuing problems in housing (over-supply of listings and foreclosures, tight credit markets)), unemployment (rising unemployment claims, expanding unemployment rate), deleveraging (how long can a total debt to GDP ratio of 375% be sustained?) and a stagnant recovery (H2 2010 GDP growth below 1.5%) seem to satisfy the necessary conditional elements of deflation well. Adding further insult to injury are Ben Bernanke’s recent doubts about the recovery and his intentions of resuming quantitative easing (by buying long-term treasury bonds). Why would the Federal Reserve feel the need to take such dramatic measures if there was no imminent threat of price deflation?
[Do you agree with the pros I’m reading that bonds are the way to go?]
[Do you see that as a trend for bonds for the immediate future?]
I would maintain holdings of medium to long term ([non-government] - the 10 year treasury at 2.57% is not a compelling long term yield) bonds in the interim if we agree with the idea that deflation or low inflation will persist for at least the next 12-18 months. It’s my intuitive sense that market participants in general are still holding on to the idea that inflation (and inflation expectations) will remain the dominant driving force of yields. What might lead to appreciation of longer-maturity (7+ years) bonds is the continued realization by market participants that the economic malaise will persist for years, thereby requiring the Fed to hold Funds rate at zero for an extended period. (Many traders calculate the intrinsic value of a bond based on the actual short term T-bill rate, expectations of the rate in future quarters, and other factors [default risk]). Currently, the market consensus estimates that the Fed will remain on hold until Q2 2011. Of course, market participants today are concerned that yields are already low and that trying to extract more gains from current levels is like trying to “pick up pennies in front of a steamroller” (cliché). It might be worthwhile/interesting to analyze bond trader sentiment in order to quantify the underlying behavioral framework of this market. Data points for sentiment might include Put/Call ratios, Volume/Price Momentum, investor surveys, and hedge/mutual fund allocations.
No comments:
Post a Comment