Green Shoots and More
06/15/09
I am a little scared. I will explain later. My last newsletter closed with these two sentences: "Inflation hawks are recommending being short bonds and short the dollar. I suspect that the better opportunity is being long bonds and being long the dollar." Boy was I wrong. If you bought 10 year bonds on that day, you would have received a current yield of roughly 3.25%. Last Thursday, those same bonds could have been bought with a current yield of 4.05%. The bond sell off was caused by managers shifting the asset allocation mix from bonds to stocks and traders trying to front run this weeks refunding auctions. Bond vigilantes might have also been spooked by pronouncements out of China and Russia, which raised doubts about the future purchasing power of their bond investments. After a Russian official said that nation would move some of its currency reserves out of Treasuries and into new bonds issued by the International Monetary Fund and after Brazil also said that it would buy IMF bonds, concerns about demand for Treasuries from abroad turned almost into panic. Minutes before the results of the 30-year bond auction were released, 10 year bonds fell to a new low for the year yielding the aforementioned 4.05%. Then the results were announced and they surprised everybody. The bid-to-cover ratio was a strong 2.68 to 1, meaning for every bond sold, there were 2.68 bids. The past few auctions were covered 2.21 on average. The low yield was also a big surprise with a 4.72% yield to maturity. Best of all, foreign buyers made up 49% of the total – the highest percentage in recent memory. Inflation may not be a threat, but my timing clearly was terrible. But that is not exactly the reason why I am scared. In our business the sin is not to be wrong but to stay wrong. No, I am scared to sound too optimistic because people may think I am a lunatic. Let me explain why I am indeed more, not less optimistic for the rest of this year and the first part of next year. It all started with an article in Barron’s on May 18th, shortly before I left for Europe. Jason Benderly of Benderly Economics was quoted expecting "the strongest profit outlook in 25 years". Being of a relatively optimistic disposition, I was immediately intrigued. The one thing that nobody was expecting then (and today) is good news. Here are some charts:
The two charts above show us the concept from the Barron’s article as I understand it. Both charts show nonfarm business sector output (blue), nonfinancial corporate business profits after tax (red) and the Dow Jones Industrial Average (green) in terms of percentage change (year over year). Recessionary periods are marked in grey. The first chart takes us back to 1948; the second chart focuses on the period 1970 to 2009. I would like to make clear that this is my personal reconstruction of Mr. Benderly’s concept. The data I used are available on the website of the Federal Reserve Bank of St. Louis. Here is how the Barron’s article explains the concept: "When a recovery happens, business output stops contracting and starts to grow again. When this swing in output occurs, however, it is an unfortunate fact of life that additional hiring does not immediately follow. One key reason business is slow to rehire is that, during the period of the downturn, it had been slow to fire. The present downturn has been no exception. As shocking as the recent layoffs have been, it still turns out that that the contraction in output has been even greater.... In a downturn, then, profits take a huge hit because output shrinks much faster than the cost of labor. But the flip side is that, in a recovery, profits enjoy a huge bounce because output grows much faster than the cost of labor." You can see in the charts that business profits swing much more violently than the output line. Benderly calculates that profit swings are 6 times greater than the output swings. Barron’s continues: "... this striking pattern of shrinking and rebounding DNFC profits has applied without exception to every one of the past eight recessions and recoveries, going back to 1954." Most analysts expect like Mr. Benderly a sub par expansion in the order of 3% or so. This should translate into an annualized profit expansion of some 18% by 2010. This coincides somewhat with earnings growth expectations of Standard and Poors. Top down strategists estimate operating earnings for 2009 to come at $43.02 and for 2010 in the order of $46.60 for an 8.4% gain. Bottom up analysts estimate $55.81 in operating earnings for this year and $74.32 for 2010. This represents an earnings gain of 33%. Somewhere in the middle around 18% seems like a good bet. Michael Darda, MKM Partners' chief economist, expects the economy to bottom some time this summer and for gross domestic product growth to reach 4% in 2010. Goldman Sachs’ Abby Joseph Cohen was quoted in this weeks Barron’s: "Goldman is forecasting S&P 500 earnings before provisions of $63 in 2009 and $71 in 2010. Regardless of the number, there is a discontinuity in the data. Some S&P 500 companies have disappeared, and recent quarters have seen extraordinary write-offs. There will be a major inflection point for earnings in the third or fourth quarter. Our analysts believe risk may be to the upside -- that is, profits may grow faster than previously forecast." Ignore these people at your own risk. I know, it sounds crazy.
The two charts above show you another reason why it may not be unthinkable that the stock market could continue to climb higher without the much hoped for 10% correction. The first chart above was constructed from data provided by the World Federation of Exchanges and the Securities Industry and Financial Markets Association. The red line represents the market capitalization of all major exchanges and the green line shows money market instruments. The grey bars show the percentage of money market instruments to equity exposure. You can see just how much cash was moved to the sidelines in 2008. The monthly data show almost no change through April 2009. The second chart shows a similar approach with a different set of data, which was also provided by SIFMA. Mutual Funds hold as much cash as they hold in equities, which is the highest percentage in 12 years. This helps explain the "buy the dip"mentality that has kept this market from falling more than a couple of percent at any one time. Investment managers are underinvested and are struggling to gain equity exposure. Felix Zulauf said in this weeks Barron’s: "Investors are underinvested in equities. Money-market funds are bigger than ever when expressed as a percentage of global equity capitalization. That money is yielding virtually nothing, and a lot of it is in the hands of professional portfolio managers who have to perform. Eventually it will get redeployed into equities, which means economic and market developments for a time will move far apart. The market undershot into March, and will probably overshoot in the first half of next year." The market is still in need of a correction, but it may turn out shallower than many investors are hoping for. The pressure on managers to show risk/equity exposure can drive this market higher longer than we may think reasonable. Now that you have seen the asylum you may realize that I must be crazy but at least I am in good company.
Hermann Vohs
"Markets can stay irrational longer than you can stay solvent."
John Maynard Keynes
Hermann Vohs is president of Cales Investments, Inc., a registered Broker-Dealer. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions. Opinions expressed in these reports may change without prior notice. Hermann Vohs and/or the staff at Cales Investments, inc. may or may not have investments in any of the markets cited above. Hermann Vohs can be reached at 303-765-5600.
This information is not to be construed as an offer to sell or the solicitation of an offer to buy any securities.
