FYI | Jul 16 2010
By BTIG market strategist Mike O'Rourke
Overview
On May 3rd, we switched to a Neutral stance on the premise that the initial recovery rally from the March 2009 low was complete. The ISM Manufacturing crossed above the 60 threshold in April. Our work illustrated that forward returns for the S&P 500 are at best average and often below average over the ensuing 1-2 years when the ISM moves above 60. That included the majority of times when a recovery was sustained, as represented by solid ISM readings over the next 6 months. We have always viewed our market stance in terms of risk versus opportunity, and in May we believed them to be balanced.
Since then, a great deal has changed. Most importantly, the S&P 500 has incurred a 17% peak to trough correction. A series of headline risks served as the catalysts for the correction. First, it started with the SEC charges against Goldman Sachs*, which in turn made it relatively easy for the Administration and the Democrats in Congress to advance Financial Reform legislation at a record pace.
That story was followed by the BP spill, although that remained under the radar for the first couple of weeks. Then there was the combination of the “Flash Crash,” and the reemergence of the Southern European Sovereign Debt crisis and the cascading of the Euro.
These developments fueled a behavioral reaction in markets where spreads blew out and Equities sold off, a reaction that we have labeled an “Echo Panic.” With the parallels to 2008, market participants reacted quickly to ensure that they avoided the same outcomes of 2008.
The catalyst for the last leg of the selloff was a round of soft economic data. To us, this is the catalyst that carries the most weight, but let us be clear that “soft” does not equate to a double dip recession, at least not at this juncture. In our June 8th note, we highlighted what market developments would make us bullish again and a little over a month later, those things have all occurred.
Behavioral/Volatility.
The Behavioral/Volatility aspect of the market was one that has been very dominant over the past 3 months. Specifically, we wanted to see the Vix get back below 30 from the extreme levels it hit in May, but noted that other indicators could also help. The Vix did get back below 30 and other indicators have helped out as well. The risk associated with a market dominated by behavioral tendencies is that an investor’s greatest risk may not come from their own poor decision making, but rather from that of a competitor.
You can do all the due diligence in the world and find the greatest investment opportunity in the world, but if someone is being liquidated, you can count on that share price going lower. For those of us who believe in reflexivity (the past two years have proven it far superior than efficient market theory), we also know that if price patterns are persistent long enough, they have the potential to exhibit real influence upon the underlying fundamentals.
We believe 2010 is the inverse of 2007. In 2007, all the market saw was “opportunity” when in fact, the writing was on the wall early in the year that there would be problems later in the year. Despite a rising interest rate environment, liquidity was plentiful. Every S&P 500 company was a potential takeover candidate. Simultaneously, mortgage originators were failing left and right in the first half of the year. The Bear Stearns Credit Hedge Funds experienced problems in June. Quant funds had problems in August, and several money funds, most notably BNP’s, were unable to access liquidity and halted redemptions. The Asset Backed Commercial Paper market froze and has never been the same since.
Today it is 65% smaller. Treasury announced a Super-SIV and the Fed started easing. The market thought all would be OK and rallied to new, all-time highs in October. The bear market bottomed last year and ever since then, wherever investors look, they see the “risk” side of the equation front and center. “Opportunity” is something many are willing to miss out on these days.
Last week, we noted that we believe the washout for 2010 has occurred based upon the very pessimistic AAII sentiment reading of 26.8% (see table). In a market that has had a boom-bust mentality for a decade, we have forgotten the short lived 20% corrections (that were brutal at the time) of the Asian Contagion and LTCM.
It is remarkable to think that LTCM, which was one of the greatest financial crises, is a mere footnote today because of two extreme bear markets registered in just under a decade. We believe that this correction was of similar variety to those of the late 1990’s. Since we have spoken at length about the AAII recently, we will not rehash it again except to say that it is an excellent indicator with an excellent history.
Investors don’t want to make the mistakes of 2008 again, and as such, discipline has been the watchword. Investors have hair triggers and are unrelenting when they decide they want to send the message to a region, a country, an industry or a company that they are dissatisfied with the state of affairs.
Since hedge funds are usually mandated to have some short exposure and are the fastest, most aggressive players, we have dubbed them Hedge Fund Vigilantes. They are the financial policemen of the global economy and are willing to rough a suspect up in order to get a point across. Although painful and volatile in the short term, this is very, very healthy in the long term.
Chart 1 below illustrates the size of hedge fund assets compared to those of mutual fund assets. As you can see back in the late 1990’s, Hedge Fund Assets were less than 3% of the size of mutual fund assets. Since 2005, they have bounced between 15% and 19%.
From our perspective, that is a good number of cops to have on the beat keeping markets disciplined. We would venture to say it is unlikely that the U.S. equity market has ever experienced a recovery with such a diverse yet sizable active investor base of mandated twoway investors out there. While it may create excess volatility in the short term, it keeps the markets healthy in the long term and brings problems to the forefront early, while they can be addressed.
Another large piece of the puzzle is mutual fund flows. Domestic equity mutual funds have only experienced inflows 4 of the last 12 months. A good portion of the rally occurred within that negative flow environment, and of course, some of the heaviest outflows occurred in May (US$19 Billion) and June (US$7 Billion).
Over the past year, Equity mutual funds have experienced US$6 Billion in outflows. Domestic Equity mutual funds have experienced US$77 Billion in outflows, during the same time period, bond funds have experienced US$396 Billion in inflows. Investors’ penchant for bonds and avoidance of U.S. equities in an environment with a 3% yield on the 10 year Treasury is a prime example that investors remain too focused upon risk and are very willing to dismiss opportunity.
Charts 2 and 3 below illustrate Total Equity and Total Bond flows over the past decade. We cannot help to point out the levels where equity flows peaked in 2000 as well as the bottoms the big outflows marked. Simultaneously, the Bond flows data illustrates investors are defensively positioned despite the low yield environment.
Economic.
Anyone who reads this note is well aware that we were waiting for Initial Jobless Claims to register a new recovery low, which they did today. One reading does not make a trend, but it is a step in the right direction. Together with the severity of the correction the market endured in anticipation of a potential double dip, we deemed it worth taking the signal.
Today’s reading was influenced by the fact that there were fewer seasonal factory closings, no matter how you spin that, it is a positive. This time last year, initial claims started dropping because of seasonal distortions as well. In that case, the auto factory closings had already occurred due to the Chrysler and General Motors reorganizations. That is a notable difference.
We recognize in May and June that data has softened, but it has not slid into contraction territory. Considering the fears of the second coming of 2008, it is understandable that business managers may have acted somewhat more conservatively until signals emerge that the double dip is not imminent. We believe earnings season will convey that message.
Investors are well aware that the past two months of private sector job growth were weak. What is often overlooked is that the two prior months were fairly strong. Considering we had the snow storms early in the year, it is fair to look at the average monthly gain, which is 98,000. We are adding jobs, albeit slowly.
Ever since this recession gained real downward momentum, investors were always well aware that this would be a jobless recovery. While it is disappointing jobs are not materializing at a quicker pace, it is not a surprise. Following the recent market correction, a slow jobs expectation has been re-priced into the stock market. The true surprise at this point would be if initial jobless claims gained some downward momentum and some material hiring occurred.
Secondary indicators such as the difference between ISM’s New Orders and Inventories numbers and Average Weekly Hours for Production workers that track GDP well are still holding up.
Valuation.
This is the big one. We watched this market correction in awe at some points as we witnessed Equities trade lower even as the economy and earnings improve. The S&P 500 is trading 13.4x the consensus estimate of US$81.71 for this year. Rather than use the lofty US$94.71 estimate for 2011, we will be conservative and use the historic 6% growth rate for US$86.61 for 2011. At today’s close, the S&P 500 settled at 12.65 that estimate. If you want to be additionally defensive and focus on the high quality companies of the S&P 100, you wind up with even more attractive multiples. The long term historic average multiple is 16x.
Barring a major fall off in earnings, this market is inexpensive. You can go one step further to note the nearly US$2 Trillion of cash that corporations are hoarding. The market capitalization of the S&P 500 is US$9.9 Trillion, if you backed out the cash, that represents approximately 20% of that and you are looking at a market even cheaper than the multiples indicate.
The bear argument generally focuses on deflation pushing valuations and/or earnings lower. Obviously, there is no way to rule out the chance of multiples compressing further, but the odds of returning to the historic average again are notably higher than that of a single digit P/E. There is little doubt in our minds that there will be multiple expansion in the future while the probabilities of compression are low, especially considering the current interest rate environment in this country.
That brings us to the Fed model and what it implies for relative valuation. The premise behind the Fed model is that the earnings yield for the S&P 500 and the Yield on the 10 Year Treasury yields historically move together.
During the 1990’s, Equities generally traded more expensively than Treasuries, but for the past decade, it has been the opposite. The yield premium or discount is the size of the spread between the two different yields. As of today’s close, the earnings yield on the S&P 500 was 7.4%, and 10 year Treasuries yielded 3%. Equities are trading at a 146% discount to Treasuries, implying that a combined equity rally/bond selloff adding up to that magnitude would be necessary to bring the relative valuation into equilibrium.
Obviously, this extreme disconnect is a representation of the large risk premium being priced into Equities as investors flock to the safety of Treasuries amidst the numerous fears in the market place. As fears subside, bonds should sell off driving the Treasury yield higher and Equities should rally driving earnings yields lower.
Below we have constructed a chart of the Fed Model. In an effort to be conservative and because we are going back to 1962, we are using trailing earnings which at US$68.76 are notably lower than current year estimates.
At the pinnacle of deflation fears in the midst of the crisis in late 2008, the equity relative discount was 270%. On July 2nd, it hit its most recent extreme of a 125% discount, a level not seen since April 2009.
Currently, the relative discount of Equities is approximately 108%. The chart, which goes back 5 decades, illustrates how extreme this relative valuation is historically. Also indicated by the red line on the chart is the 1 year forward returns that occurred from each reading.
As the chart shows, in most cases when Equities were inexpensive relative to bonds, the forward returns were pretty good. Even for those who argue that “this time it is different,” we would note this as an example of a market that has already discounted a very weak environment as evidenced by the high risk premium.
We started the note discussing the Behavioral/Volatility risk associated with this market. Again, in an effort to be conservative, we devised a metric to account for the outsized behavioral risk in the marketplace. In the current environment the low Treasury yield partially represents a flight to quality bid because of market volatility.
In such a case, just because Treasuries are expensive, it does not necessarily mean that equities are cheap. As such, the BTIG Fed Model with Risk Adjustment takes the value of the Volatility index, divides it by 10 and adds it to the 10 year Treasury yield. In doing such, the rise in the Vix in times of stress will offset a large portion of the decline in Treasury yields during a flight to quality move.
The chart below illustrates that the relative discount of Equities is not nearly as juicy as the traditional Fed Model, but with that being said, it is still very attractive. Considering the extreme discount achieved during the heart of the crisis was 88%, the current reading of a 61% relative discount appears very enticing since the world is in a much better place today (even though there are still challenges out there).
In short, on a risk-adjusted basis, this is a superior buying opportunity than the depths of the crisis.
Summary
In 2007, the market saw opportunity everywhere and failed to see the risk. In 2010, the market sees risk everywhere and fails to see the opportunity.
What is unequivocal is that the large U.S. corporations that comprise the S&P 500 are the healthiest part of the U.S. Economy. They are healthier than the delevering consumer and the levering Government. Despite that fact, fear continues to drive investors to bonds and to avoid the tremendous opportunity presented by Equities.
The equity market washout over the past couple months has strengthened our resolve that Equities have experienced another significant round of liquidation, again leaving people out of position for even a subpar recovery. We can only imagine what would happen if jobs momentum increased. The new low tick in the initial jobless claims is a step in the right direction.
For nearly a decade, we looked at an economy that continually over-levering acting greedily and irresponsibly and the market did not blink until it was too late. Now, most of the bad actors have been put out of business. The weaker competition has been eliminated.
Today, the top corporations in the world have trimmed all the fat and are flush with cash. Will they use it for buybacks, acquisitions, dividends, hiring, cap-ex? The answer is yes a combination of the above, they hold the cards and have the options.
Just as investors quickly exercise discipline to avoid the mistakes of 2008, so are companies, so soft patches are to be expected. For those who are investing as opposed to speculating, this environment offers a tremendous opportunity. This is the environment where buy and hold should prevail.
Likewise, speculators will have many opportunities, but it seems many are so focused on the short term that the long term gets lost. We see potential for this market to rise above the 2010 highs to the 1250 level over the next 6-12 months. If jobs can garner any momentum, it will be at the shorter end of that time horizon.
The views expressed are O'Rourke's, not FNArena's (see our disclaimer).
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