WHILE YOU WERE SLEEPING

It is pretty well a sea of red to start off the week with equity markets showing losses across Asia and Europe (Asia, ex-Japan, hit a two-week low today). Bond markets are quiet except for countries like Belgium, Hungary, Spain, and to a lesser extent Italy where yields are melting up rather significantly.

 

The U.S. dollar is firming — literally just weeks after breaking below the 50-day moving average as Mr. Investor adopted this pie-in-the-sky view of how the clouds were parting in Europe, the DXY is making a serious run today back at its the 100-day moving average (where it failed miserably nearly two-months ago). The euro is now trading at a four-month low as Portugal becomes the next country being fingered for a bailout package —Germany has all of a sudden become radio silent on its opposition. See Portugal in Market’s Hot Seat on page C2 of the WSJ. Spain is next, then Belgium. Then Italy. Then maybe even France. This story is just as contained as the Asian crisis was limited to Thailand 12 years ago). Credit default swaps are widening to record levels across the periphery, even in Ireland (+21.5 basis points to 677) which supposedly just received a bailout late last year.

 

On the economic data front, we saw U.K. home prices take a 1.3% MoM dive in December, as in the U.S.A., the spectre of renewed real estate deflation looms very large in the macro outlook. With the global backdrop dimming a bit here, much of the commodity complex is correcting outside of oil as a three-day decline is being reversed by the post-leak Alaskan pipeline shutdowns.

 

Tell us that 2011 is not starting off like it did exactly a year ago:

• A good start to the year for the S&P 500.
• Visions of economic acceleration after a big Q4 GDP pickup.
• Hopes of government stimulus abounds.
• Liquidity is everywhere: ditto for complacency.
• Bonds are viewed as being for losers after they were trashed in December.
• And then — bad news out of Europe causes some painful shrinkage in the P/E multiple, and after hitting a new cycle high (1,150) the S&P 500 goes on to lose nearly 100 points in the next three weeks.
• The VIX was 17 a year ago — where it is today — and over that three-week span, it jumped to 27.
• Remember, back then it was only Greece. The contagion is now clearly spreading — oh, and only affecting 25% of U.S. exports.

 

As the charts below illustrate:

 

Last year’s equity market was saved in the last four months by the last rabbit Ben Bernanke could find in his magician’s hat.

 

 

The year was rocked with volatility as there were no fewer than eight mini bull and bear markets. The bulls today seem to have no recollection of how they were feeling last August. Memories are very short in this “what-have-you-done-for-me-lately” business. “Lately”, today is now defined as weeks, months or a quarter perhaps, but this recurring volatility means that returns must be risk-adjusted at all times AND that long-short strategies that aim at capital preservation themes make imminent sense.

Finally, as the third bar chart below vividly illustrates, there were other ways to generate returns in 2010 than merely being “long” the stock market. While we were not “overweight” equities, a classic barbell between hard assets (precious metals and commodities) and income-generating assets (bonds, credit and REITs) would have generated a net return of close to 30% and basically doubled what the S&P 500 managed to achieve. So it’s not about being bullish or bearish on equities, which seems to be the only way you get measured in the popular press, it’s about how to make money and limit your downside risk all at the same time. Nothing more. Nothing less.

MARKET THOUGHTS

One has to really wonder about a stock market (talking about the S&P 500 here) in which 134 points of the 143 points that were racked up in 2010 occurred in the first trading day of each month (see The Trader on page M3 of Barron’s). That is truly remarkable ― 94% of the entire year boiled down to 12 sessions. And what do you know? 2011 started with a 1.1% pop and has sputtered since.

 

It is truly the nuttiest thing ― the best days last year were the first day of each month (save for June and July) and then after that there were practically no crumbs to nibble on: These are the point changes for the first trading day of each month in 2010, which totals 134 points (as we mentioned above): December +26 points; November +1 point; October + 5 points; September +31 points; August +24 points; July –3 points; June -19 points; May +16 points; April + 9 points; March +11 points; February +15 points; and January +18 points.

 

Now look at 2011 ― +14 points to kick off the month and year, to close at 1,271.87, and here we are today, after a supposedly ripping ISM and ADP set of numbers, and as of January 7, the S&P 500 is sitting at 1,271.50. Hope you didn’t decide to get in on the second day.

 

As for bond yields, the nice backup in December, as was the case a year earlier, has set us up again for a 2011 of decent returns. After a bit of a struggle at the onset, we have the yields across the U.S. Treasury curve out to the 5-year maturity (very nice 10 basis points rally there on Friday too), lower now than they were at the end of 2010. The 10-year note yield has also rallied nicely after the opening day selloff. Ignore the masses and stay the course. Bonds still offer decent value with the long Treasury yield now nearly 270 basis points above the S&P 500 dividend yield (you won’t hear that discussed much on Wall Street since broker commissions are driven by stocks, not bonds).

MORE ON THAT TEPID PAYROLL REPORT

It was so interesting to see all the “about faces” following the release of Friday’s data. It was just on Thursday, for example, that the Globe and Mail ran with U.S. Jobs Growth Point to Turnaround and then on Saturday with New U.S. Job Figures Fail to Match Expectations. While there were no shortages of economists putting lipstick on this pig, at that phenomenal rate of 103k on payrolls, it would take 70 months (to 2016) for payrolls to recoup all the recession losses. Watching paint dry promises to be more exciting.

 

The Globe shouldn’t take it to heart. A whole slate of economists got sucked in, yet again, to the increasingly spurious ADP poll. Even the folks at the Fed can’t seem to sing from the same songbook ― here we have, on the same day, Ben Bernanke trying to convince us that he is seeing signs of a “self-sustaining recovery in consumer and business spending” taking hold, to only then have Chicago Federal Reserve Bank President Evans come out and state that the data “do not yet point to the kind of robust, self-perpetuating recovery that we need.”

 

In reality, there was nothing in the December’s employment report to get too excited about. Here we are, a full 18 months into a recovery when what is normal is that payrolls start to come in by +180k. So sorry, +103k is abnormal and highlights the continued fragility of the domestic economy.

 

Outside of the recurring massive amount of monetary and fiscal support, it is safe to say that we would still be in recession. Looking through the monthly wiggles in the data, payroll gains in Q3 averaged 124K, and in Q4 it was 128K. Wow. Some improvement. And the gap between the median weeks of unemployed (22.4) and the average weeks of unemployed (34.2) is 11.8 weeks. Last year at this time it was 8.9 weeks. This could well indicate that the ranks of the long-term unemployed are getting larger with each passing month.

 

There are so few out there today willing to look past the next week, month, or quarter but the future is a very murky one in so many respects, especially the social ramifications of the 6.4 million long-term unemployed and the longer they are out of work, the lower their chances are of re-employment. Luckily for them, the unemployment benefits were extended, but by next year they will most likely be on state welfare rolls ― so long as the states can afford it.

 

What about college graduates? The employment-to-population ratio for this cohort has plunged from 67.1% three years ago to 62 % today. This is a dark cloud over the future productivity backdrop.

 

Yes, yes, the Household survey did offer up some good news but it followed two horrendous months and the employment trend is still very weak. Keep in mind that for 2010 as a whole, which turned out to be a good year for investors courtesy of the ongoing support from the Fed and the Federal government, the unemployment rate averaged 9.6%, the highest in 27 years and above the 9.3% rate of 2009 when the economy spent half the year in the worst recession since the 1930s.

 

As for the month-to-month drop in the unemployment rate from 9.8% to 9.4% that we saw on Friday, the reason for that was the 36,000 Americans who terminated their job search in December. On top of that, what job gains we had last month were in the lower-paying leisure, hospitality, education, and health service industries (which is why it was so strange to see the diffusion index rise as it did). And along with a stagnant workweek, it looks like organic take-home pay was flat in nominal terms and down in “real” inflation-adjusted terms to close out the year. Wonderful.

 

Temp agency employment rose 16k in December, up now for five months in a row, and ended up accounting for about 30% of the total employment growth in the economy last year. Sadly, what was once a good leading indicator of future labour demand is now merely a sign of the times ― a “just in time hiring” strategy for companies that continue to focus on cost cutting to drive their bottom line performance.

 

 

NO SANTA RALLY IN THE CONSUMER

Well, well. Looks like the American consumer got a bit tapped out with the November binge. Same-store sales in December came in at +3.2% YoY which were below expectations for a 3.5% gain. Just over half of the industry (52%) missed their sales targets. Clothing has been hot with sales up 11% on a YoY basis (are consumers pre-buying ahead of the springtime markups as the cotton-effect filters through?), as has jewellery and web retailing. Outside of that, things are actually pretty soft, particularly for electronics (partly owing to the lack of any new product cycle as Best Buy came in with sales that deflated 5% YoY in December) and home furnishings (the housing sector is still in sick-bay). Moreover, this consumer slowdown may be going global because we already have seen Chinese auto sales moderate and Euroland posted an outright retail sales decline of 0.8% in November. Begs the question as to how much of this worldwide production bulge to close out 2010, that was so evident in all the ISMs, is going to go straight into the inventory bins.

GLOBAL INSTABILITY

First off, with inflation in China over 5%, Chinese policymakers are going to spend 2011 in restraint mode. Count on it. Better pricing levels in most commodities lie ahead even if they do remain in secular uptrend. It’s not just China that is now battling heightened inflationary pressures — it’s almost the entire emerging market world (Brazil, Argentina, Venezuela, India, Indonesia, Vietnam, Malaysia, and Thailand, just to name a few). See Inflation Fears Put Investors on the Defensive on page 15 of today’s FT.

 

Second, we are in the throes of a global currency war and late last week we saw Brazil move aggressively to rein in the real’s strength by imposing reserve requirements on domestic banks’ foreign exchange positions. Brazil extends a growing list of countries opting for de facto currency controls, which in turn is a destabilizing global trend that plays right into the hands of the gold bulls. Have a look at Tensions Rise in Currency Wars on page 4 of today’s FT, as well as the front page story titled Trade War Looming, Warns Brazil. The increase in reserve requirements comes despite the fact that Brazil’s inflation rate just hit a six-year high and can probably use a stronger exchange rate as a valve to restrain price increases. Be that as it may, these attempts globally to weaken currencies certainly increases the allure of the precious metals complex as a substitute.

 

Third, we have food prices surging and this is very likely going to cause social strife in the emerging market world ― India, China and Indonesia come to mind. Investors can purchase volatility today at bargain-basement levels. Millions of people in India spend over half their budget on food, and prices there are now rising at nearly a 20% annual rate.

 

Fourth, there is no doubt that returns on equity have been on an uptrend and this has added reinforcement to the bear market rally in equities. We went into 2010 with the consensus for operating EPS at $78 for the S&P 500 and by year-end it now appears that the figure will be closer to $84. But the consensus of $97 for 2011 looks far too aggressive, especially since energy prices are going to be a major margin crimp this year. The impact of oil prices on the economy is statistically significant even with a two-year lag, and never before has a 120% surge on a two-year basis in WTI failed to engineer a contractionary economy. Alas, this did not make it Byron’s legendary top 10 surprise list even if it made ours (see Market Predictions, With Many Grains of Salt on page 4 of the Sunday NYT business section).

 

Fifth, the Eurozone sovereign debt situation is looking increasingly tenuous (see The Crisis That Isn’t Going Away on page B1 of the Saturday NYT ― a must read).

And the slides of March will be a tipping point for investors to start assessing default risk and what that means for European banks because if the opposition party in Ireland emerges victorious in the national elections, then a debt restructuring is very likely in the offing. Final domestic demand in nominal terms is at a six-year low in Ireland and the unemployment rate is at a 16-year low so what incentive is there really for Ireland to accept this so-called EU deal that makes this elongated recession even worse? Bankers beware.

As it stands, based on our calculations, credit default swaps are trading as if Greece has a 70% chance of defaulting, 51% for Ireland, 44% for Portugal and a nontrivial 31% for Spain. Both Greece and Ireland are now paying over 80% of their export revenues towards external debt payments, which is not sustainable by a long shot ― as the NYT aptly concludes: “governments will find it much harder to justify further squeezing their hard-pressed citizens on order to pay foreign creditors”. A major developed country has not defaulted on its debt in six decades but that may be about to change. And the fact nobody around trading the market has ever experienced something like this makes it that much more unnerving. Yet, the vast majority seem to be whistling past the same graveyard they were back in 2007 when they hadn’t seen a national home price decline of more than 10% in seven decades either (a 30%+ slide is what eventually happened, in direct contrast to what Ben Bernanke told us was going to happen just months before the real estate collapse).

 

Is anyone paying attention to what is going on? The pressure is clearly building with market interest rates soaring across the periphery ― Portugal’s 10-year bond yields have blown back well above the 7% threshold after a 60 basis points surge this past week (7.14% to be exact, despite aggressive ECB buying). Ahead of this, Wednesday’s bond auction, which is going to serve as a very important litmus test as to whether it can actually fund itself, the runup in market rates in turn caused a selloff in Portuguese banks to 17-year lows (as an aside, Ireland hasn’t been able to float a bond in four months). If it cannot fund itself, then the country is going to probably require a bailout like Greece and Ireland.

 

Spain is also seeing yields back up to 5.5%, which would be the highest since the advent of the Euro area. Part of the problem is that Germany and France are also coming to market to fund their deficits and posing competition for these other fiscally-challenged (being polite here) countries because investors are flocking towards the paper that is rated AAA. But even in the case of say, France, it had to cheapen up its bonds ahead of its recent auctions as well. And in Belgium, we have a destabilizing political stalemate (how apropos that Brussels is home to the EU) ― bond yield spreads in Germany have exploded to over 400bps. No wonder the euro is back flirting near four-month lows.

 

The European situation hit the front burner last year in January, April and again in July. These were the parts of the year when the equity markets looked the most wobbly. Of course, the U.S. economy also hit a bit of an air pocket in the spring and summer too. All we can say is that 2011 is going to look quite similar ― a solid Q1 (already priced in) for GDP growth followed by a weak Q2 and Q3 (this time around, it is because the tax-cut effects are concentrated in Q1 and so there will be loss of support arithmetically for spending in the second quarter in particular) and like 2010, a Q4 bounce (this year led by capex growth ahead of the termination of the bonus depreciation allowance).

Sixth, we have a showdown looming now between the Congress and the White House over the debt ceiling issue. We are now just $300 billion or three months away from hitting the statutory limit of $14.2 trillion (can you believe that amount? Jefferson and Hamilton must be rolling in their graves). It is doubtful that we will see the U.S. government miss a debt payment or a secular security payment for that matter, but this “noise” could create some market volatility and a pull-back in risk appetite from today’s very high levels. While there will likely be a deal struck to avoid a catastrophe, this will not be the same “goose” as the fiscal system deal that was struck with the lame duck Congress a month ago ― this one will involve the White House agreeing to spending cuts as some semblance of the former pay-as-you-go rules come back into fashion. It is doubtful that the fiscal conservatives will get the $100 billion spending restraint they want but it looks like a line is going to be drawn in the sand at $60 billion and that right there is equivalent to 0.5% of GDP. And at that point, GDP revisions for the year will likely be towards the downside, not the upside. Since this is likely to dominate the landscape in February and March, now would not be a bad time to be reconsidering pro-cycle trades. Have a look at In Discord Assembled: Bickering and Stalemate Loom for America’s new Congress on page 25 of the Economist.

 

Seven, we have escalating fiscal drag at the state and local government levels that is going to likely impose $65 billion of drainage from GDP growth this year. (And the pressure is going to be on state and local governments to tighten fiscal policy and re-write their social contracts with the public sector unions because Bernanke said flat out on Friday that the Fed has absolutely no intention of adding the debt of lower levels of government to its already spurious balance sheet.) This is one reason why 3-4% GDP growth estimates and 15% profit growth projections seem so optimistic to us. State and local governments are the largest contributor to domestic spending in the economy after the American consumer. Illinois, which is the second largest fiscal basket-case after California, is in the process of debating a 75% hike in state income tax rates.

 

Number eight is of course the housing market ― see Housing Statistics Hit Rough Waters on page A4A of the weekend WSJ. Home prices are down four months in a row and are now back declining across all 20 major metro areas. Now watch liquidity totally dry up in the aftermath of this ruling by the Massachusetts court that Wells Fargo and U.S. Bancorp (two of the nation’s largest lenders) failed to show they were the holders of certain mortgages at the time of foreclosure. As a result, investors are now realizing that the banking sector in general is going to face difficulties going forward to initiating foreclosures in mortgages that were repackaged into asset-backed securities. Then again, we have to be careful here because strategic defaults have managed to emerge as a key source of stimulus ― see Facing Scrutiny, Banks Slow Pace of Foreclosures on the front page of the Sunday NYT ― to wit: “It is not that borrowers have stopped defaulting on their mortgages. They are missing payments as frequently as ever, data shows.”

So the reason for owning the financials was what again? Talk about a flawed industry.

 

LAND OF THE RISING SUN?

We get accused of being bearish on equities. Yes, that is correct, if we are talking about U.S. equities. We never did say we were as bearish on, say, Canadian equities, because the banks here offer up a dividend yield that is triple what you get in the S&P 500 and resource exposure that is also three times as pronounced. It just so happens that the Canadian equity market generated a net total return of over 20% in U.S. dollar terms in 2010, which was a good 600 basis points higher than what the S&P 500 managed to generate (and all of it after Bernanke pulled another joker out of the deck). In fact, our friends south of the border may want to know that the Canadian stock market has outperformed the U.S. stock market in eight of the past nine years ― the only miss was the Black Swan year of 2008 ― during which time the S&P 500 has averaged a 3.3% net return annually and the TSX up 8.5% in local currency terms and 16.6% in USD terms.

 

So if you want exposure to equities, why be focused on the post-bubble economy that is still overvalued by more than 20% on a Shiller P/E or a Tobin Q basis and one that has totally mortgaged its future to buy growth for the present? If you want value, a market where all the bad news has been priced in, that has lagged woefully behind, that is ignored by the analysts, underowned by global portfolio managers and has seemingly found a way to stop its currency from appreciating to new overvalued highs which until recently was crimping its large-cap multinationals, it is Japan.

 

So the answer is no ... we are not “perma bears” by any stretch. We simply don’t believe that just by putting up a picture of George Washington crossing the Delaware is a good enough reason to incentivize investors to overweight the U.S. stock market. In fact, there were so many asset classes that did so much better in 2010 or at least as well in risk-adjusted terms. Japan trades at book value versus 2x in the U.S.A. and Europe. Forward P/E ratios are barely higher than 13x, about the most compelling they have been in the past two decades. According to the FT, 25% of Japanese companies trade at a single-digit multiple compared with a mere 4% in the U.S.A.. The Nikkei was down 3.0% last year even as practically every other market rallied, so it does have some catching up to do and the market decline in 2010 obviously opened up some serious value. Analysts globally have been dropping coverage of Japanese stocks ― a contrary bullish signpost. According to the FT, the dividend yield in Japan now exceeds the sub-2% you get in the U.S.A. and yet the market there competes with a 1% JGB yield compared with a 3.3% yield in the United States.

                                                                                                                                                                               

Q4 EARNINGS KICKOFF

Alcoa, Intel and JP Morgan kick off the fourth quarter earnings season this week. Expectations are running high ― the consensus sees +32% YoY EPS growth for the S&P 500 companies, though much of that reflects a depressed year-earlier base, especially related to the financials where the consensus is at +1,383% (you read that correctly). Ex-financials EPS is seen at +11%, led by materials (+27.9%), energy (+25.9%), telecom (+13.3%), tech (+13.1%) and consumer discretionary (+12.7%). Utilities, staples and health care are the laggards. The focus will be largely on the top-line because few believe there is any more room for margin expansion from cutting labour costs and raw material input prices are soon to bite ― on this score, revenues are seen rising 6% YoY in Q4, a tad slower than 7% in Q3 and 8% a year ago ― the analysts are penning in +5% for Q1 too. Earnings projections go from +32% in Q4 to +12.5% in Q1 to +10.8% in Q2. So the bottom line is that the comps are getting tougher and growth is becoming more scarce. See Profits Face Headwinds on page B1 of today’s WSJ. Airlines, in particular, were viewed as being particularly vulnerable to margin pressure.

 

For a nifty article on the gap between profits and job creation, have a look the article on page 4 of the Sunday NYT’s Week in Review section: Profits are Booming. Why Aren't Jobs? Well, the bulk of earnings this cycle were derived offshore and since U.S. companies get “dinged” on earnings they remit home what happens is that the foreign-derived income stays where it is ― locked up abroad. Second, why on earth should companies pay their employees more when Uncle Sam is willing to provide 20% unprecedented support for personal incomes. The next question of course is how sustainable all the government largesse can be, even before the rise of the bond vigilantes, we have this new crew of fiscal conservatives now dominating the agenda in the House of Representatives.

 

(c) Gluskin Sheff

www.gluskinsheff.com