FYI | Dec 21 2010
By BTIG chief market strategist Mike O'Rourke
"I can be reasonably certain of only one point: My economic forecast is highly likely to be wrong – but I don't know how."
(Federal Reserve Vice Chairman Don Kohn, April 8, 2010)
This is the time of year for forecasts and predictions. We genuinely believe retired Fed Vice Chair Kohn's may be the wisest words ever spoken by a Central Banker. Accordingly, we don't think our own ability to make such prognostications is any better. The investment journey is often discussed in terms of a roadmap, but we have always found a compass to be a much more fitting description. A roadmap has far too much detail. It tells you what is around every corner and in the uncertain world of financial markets, that is unrealistic. On the other hand, a compass simply confirms that you are heading in the right direction. With just a compass, you don't know if a tree has fallen in your path a few miles out, or if it is a downhill walk on a smooth surface. For investors, dealing with this uncertainty is good because it requires that you be prepared no matter what the outlook. Like others, we don't view the passing of a date on the calendar as providing any revelation that one's outlook should dramatically change. Therefore, most of the themes on which we are focused are ones that we have been watching for some time, but this is an opportunity to string them together. Our current view has three key themes: Investor Positioning, Valuation and Global Growth.
Investor Positioning
We view investor positioning almost equally as important to valuation as determining market direction. Most market participants have experienced either top down or bottom up equity market moves in which stocks or an index with awful valuation went up and continued to go, and go, and go. Likewise, value traps have been common, where the earnings are there now but will not be in the future. In the first case, those who need to own the stocks do not and in the second, just about everyone owns them because they are so cheap. We have been Bullish throughout the majority of the past two years. The exception was when we went to Neutral from the start of May to mid-July. Although the S&P 500 is on the cusp of re-claiming pre-Lehman levels, we believe there is a large numbers of assets that need to increase their levels of equity exposure and that transition will begin now.
From our vantage point, 2010 has been a speculator driven market. The vanilla investment community has been in a defensive, deleveraging and re-liquefying mindset for 3.5 years. A historic shift has occurred from Equities to bonds, despite the low interest rate environment. As such, Hedge Funds have become the predominant incremental investor. In addition to the tremendous growth of Hedge Fund Assets relative to Mutual Fund Assets over the past decade, the turnover levels of the Hedge Fund community are multiples of that of the vanilla community. In turn, fast money has aggressively rotated in and out of trades and assets classes. The result has been rapid moves in succession, increased bouts of short term volatility but all in all, a much healthier market place. For decades, vanilla investors, both institutional and retail, dominated the flows. These investors generally fueled the rising tide that not only lifted all boats and easily blunted and absorbed the volatility of fast money making quick trades. When the 17% correction occurred in the spring, the fast money community exhibited its penchant for risk management cutting exposures quickly and moving on to the next trade. As the QE trade dominated over the past 6 months, Equities, although they received flows, were the third asset class in a 3 asset class race. It is our view that this has left a number of investors with Equity weightings below levels at which they want to be as the economy recovers.
Valuation
Although we believe Investor Positioning to be almost as important as Valuation, Valuation is the key to sustainability of moves. We have all seen some stocks and indices trade with extremely lofty P/Es for extended periods. Some instances have even lasted in excess of a year(s), but usually, reality sets in. According to Standard & Poor's, 2011 estimates for S&P 500 earnings are $94.65. As of Friday's close, the S&P 500 is trading 13.1x estimates. Using a more conservative $90 estimate, the S&P 500 is trading 13.8x estimates. In either case, both provide ample room for multiple expansion to begin moving the P/E back to the historic average multiple of 15.9x earnings before investors get concerned about Equities moving into "expensive" territory.
The S&P 500 has endured a decade of multiple contraction after a period of excess. Now that a cleansing has occurred and healing has begun, the process of multiple expansion will likely begin. What we believe to be the most important aspect of the earnings and valuation story is that it only takes 5% earnings growth in 2011 for the S&P 500 to post a record year of earnings. The current 2010 estimate is $83.61. Five percent growth next year will put earnings slightly above the record earnings of $87.72 in 2006. As the world slowly returns to a sense of investment normalcy, being able to purchase an index posting record earnings that is at the same levels it was 12 years earlier is a very attractive proposition. Even more importantly, the pressure will rise on the investment community to be there participating as that realization goes mainstream. Hindsight risk, will be placed upon those who are not participating. We expect that the prospect of record earnings, together with low bond yields, will prompt vanilla investors to return to Equities in 2011.
Global Growth
Global Growth is the last key theme of our view. We believe the Global Growth story is alive and intact. The Great Recession created a reset for U.S. multinationals which were provided with the opportunity to downsize where growth was slowing and reinvest where it is picking up. Large corporations are now flush with cash and have the opportunity and resources to invest in markets offering the best potential. Below is a table of global growth forecast and S&P 500 Earnings. Next year, global growth is expected to increase 4.22% down from 4.8% in 2010. We also highlight that in the decade prior to 2008, the global growth average was just shy of 4%, suggesting that a 4+% growth world still provides ample opportunity for earnings to grow and that the 5% earnings growth necessary for record S&P 500 earnings is a likely scenario.
Risk Factors
Finally, there are the risk factors. In the uncertain world in which we live and invest, they are always there. Their importance escalates with their probability and investor positioning. There are many well known risks of which investors are aware in the market: Sovereign Debt, U.S. Federal Debt, U.S. Municipal Debt, U.S. Pension Liabilities, China Economic Slowing, Trade War fears, Inflation, Geopolitical Risk (Korea, Terrorism, etc), and the list goes on. We believe each is a legitimate threat in its own right. The risk we fear the most is China's economic slowing. We don't expect it, but we would not rule it out either. As always, the key is timing. When investors are defensively positioned as they currently are, and the shocks are known, they are easier to digest. When that risk exposure ramps, those risk factors are harder to shake off, but we have been in a net selling environment for 3.5 years, and we expect it will be a multiyear process of re-allocating to Equities. That does not mean there can't or won't be problems, it just means that at this point, we don't see them derailing our Bullish views.
The views expressed are O'Rourke's, not FNArena's (see our disclaimer).
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