Tower Private Advisors
- Sentiment getting overstretched: short-term pullback ahead
- GMO quarterly letter and its takeaways are well worth your time
- States’ fiscal conditions may not impact state municipal bonds as badly as some expect
- Good economics this week; big week, next
This one’s a bit long. Read the underlined parts and you’ll get the gist.
Capital Markets Recap
It may be that investors had gotten too complacent and decided to price back in some fear or it may be something more insidious, but the S & P 500 was down by just 0.56% this week, but implied volatility (aka the Fear Index) jumped by 18.29%. What it implies remains to be seen. You can infer what I think it means by reading further.
Earnings continued this week with 156 companies having reported earnings between Monday and Friday morning. Unlike last week’s results, there was a slightly positive correlation between stocks reporting earnings surprises (i.e. earnings beat estimates) and stocks with positive 5-day rates of change, as the chart below shows. Still, the R-squared of 0.027 tells us that just 2.7% of the stock-price movement is a result of earnings, alone.
From here, things start to taper off, with just 102 companies reporting next week. We’ll have to start looking for the next bogeyman behind stock price movement, even though the chart above suggests that earnings results have next to nothing to do with stock price movements in aggregate.
So far, we seem to be doing a bit better than average. 81.9% of companies have beaten estimates, as compared to the more typical 70s level. The best results have come from the finance sector, where the average result has been 18.4% better than the consensus EPS estimate and 108.63% year-over-year improvement, followed by consumer discretionary, where the respective figures are 11.24% and 31.70% Information technology and industrials were the almost-tied second best for year-over-year growth, at 56.61% and 55.43%, respectively. The telecommunication sector (only nine companies in toto) is the only sector showing negative year-over-year growth at -9.20%.
Sentiment toward stocks is again becoming a bit frothy. The oldest sentiment survey is the Investors Intelligence survey of investment newsletter writers. It showed a troubling 45.6% of newsletter writers were bullish. That’s not a freak-out, head-for-the-hills level, but it’s enough to be worrisome. Freak-out level is about 55%, which was seen in early May.
The cute little creature below right is a lemming. He/she has the nasty distinction of having a habit of running off cliffs en masse. It turns out that a 1958 Disney documentary on the subject was highly doctored to show the critters leaping headlong into the sea. Nevertheless, the image stuck. In investments, the lemmings’ thinking is captured in the weekly American Association of Individual Investors (AAII) survey. Unlike the II survey, which shows a ways to go before sentiment gets frothy, this group of folks has more bulls (%) than at any time this year (chart below.)
Investors Intelligence also tracks what it calls Buying and Selling Climaxes. A buying climax occurs when a stock–in a week–reports a 52-week high (low for a Selling Climax) but closes the week (Friday to Friday) down by 10% (up for a Selling Climax). It essentially captures the weak hands buying from the strong (buying climax) and vice versa .Buying climaxes reported on October 25 came with this one-liner: Buying climaxes jump – now approaching dangerous levels. They reached their highest levels since late July, which is right about when stocks took their nasty September–yes, that’s right, September moved forward to August–drop on the heels of investment expert Glenn Beck’s featured Hindenburg Omen.
There have been ample reasons for stocks to rally, namely Quantitative Easing, next week’s elections, earnings. QE, again, is when the Federal Reserve tells the Treasury to crank up the printing presses so it can buy securities. Elections are when the electorate gets to choose between the lesser of two evils. Earnings occur when companies manipulate their income statements to produce positive bottom lines. QE, extrapolated ad infinitum, means that risk assets (i.e. stocks) will go up. The election means that we’ll have Congressional gridlock–as opposed to the fluid superhighway we’ve had for the last two years, when stocks have done better. We’re also entering the–stop me if you’ve heard this–best year of a President’s first term AND the fourth quarter of year two . . . uh . . . now, Gordo, for stocks. Finally, as noted above, earnings have been better than expected–as usual–and better than as usual.
Here’s the punchline (man, I hate that one): stocks have had plenty of reasons to rally, so they did. We think it’s time to sell ahead of the news, reducing or hedging stock exposure in individual-security portfolios. A well-worn investment saying is buy the rumor; sell the news. So do it.
Now don’t get me wrong, the table is being set for positive results in a medium-term time frame (think 1-12 months out); it’s the short term that is troubling, as is the long term. As to why the medium term looks good . . .
- While there’s ample reason to call the current environment different (they all are), the Presidential cycle has not been repealed.
- QE will produce excess money, which will flow into risky assets (my guess for the next bubble is emerging markets).
- The only factor above which shouldn’t be cited as a force for the next year is earnings. That bar is being set higher, and stocks do better when it’s lower.
Still, we think the market has fully absorbed those positives; thus, the short-term direction is lower.
Jeremy Grantham, of GMO, might be one of the sharpest minds around when it comes to top-level discussion of asset classes, economics, and prevailing winds. His most recent Quarterly Letter was titled Night of the Living Fed, and featured the following cover image.
In it he castigates the Federal Reserve for recklessly fostering asset bubbles, acting before and during as if it can manipulate markets, and then claiming afterwards it was helpless in seeing–much less addressing–asset bubbles. In one breath, the markets are inefficient and we can affect them; in the next, markets are efficient, and who are we to interfere? The Fed is presently attempting to prop up/goose the stock market by printing money (politely, Quantitative Easing), because, “the market is far more sensitive to monetary factors than is the real economy.” A rising stock market will produce a wealth effect, making consumers feel like spending more. Last time they did that, they produced the housing bubble, a far more serious affair, in which, Jeremy claims the housing-related employment likely masked a structural decline in employment.
Here are his asset class implications, all direct quotes except where noted.
- Emphasize U.S. quality companies, which are still cheap in an overpriced world
- Moderately overweight emerging market equities
- Moderately underweight the balance of global equities
- Heavily underweight lower quality U.S. companies
- Carry extra cash reserves for a volatile market with insecure fundamentals
- For the very long term (20 years) overweight resources [his view, not GMO's]
- Also, that in spite of “if ever there were an argument for “this time is different,” this is it, year three of the Presidential cycle (2011) should be a good one
- [Paraphrased] If the value of paper currencies are based on faith, how much more is gold, which “pays no dividend, cannot be eaten, and is mostly used for nothing more useful than jewelry. . . I believe that resources in the ground . . . are more certain to resist any inflation or paper currency crisis than is gold.”
I read a copy of Moody’s Special Comment, Why US States are Better Credit Risks Than Almost All US Corporates.” It focused special attention on the plight of Illinois, as it takes the honors of state-in-deepest-doo-doo, and used the strengths of that state to bolster the case for all states, and in turn, general obligation municipal bonds of all states. As an aside, Illinois could eliminate its annual budget deficit with a 2% high in its income tax rate; not pleasant, but not a killer. Here are the strengths of state G.O. debt versus corporate debt:
- Unlike a corporation, states can increase revenues without mitigating capital spending
- Expenses can be reduced without hurting revenues, unlike with a corporation
- There are strong legal protections for debt service payments–in many states, those payments rank above those to vendors
- Limited ways to avoid debt obligations, unlike the bankruptcy protection for corporations
- Recovery in the event of default is expected to be considerably higher
- Reduced confidence in state “management” less important than with a corporation
- Little competitive pressure amongst states vis-a-vis corporations
- Less event risk and the possibility of federal government support
As of this Friday morning the economic news has been, almost across the board, good. Existing Home Sales were better than expected: 4.53 million (annualized rate) versus 4.30 million (expected) and August’s 4.13 million. The Case-Shiller Home Price Index grew at 1.70% in August, albeit at a slower pace than in July, but notice that the data is a month behind the existing home sales and . . . New Home Sales grew by 307,000, versus August’s 288,000 annual run rate and the expectation for a 300,000 rate. Initial Jobless Claims fell by an unexpected 21,000 from last week’s upwardly-revised 455,000. The resulting 434,000 were 16,000 better than the 450,000 the dismal scientists expected. Today gave us the first look at Q3 GDP. It grew by 2.0%, just as the economists foresaw. (We’ll get two more, refined releases of the same data at the end of November and December.) At 70% of GDP, it goes without saying that consumer spending is a huge part of each quarter. Q3 saw the best level of consumer spending (aka Personal Consumption Expendituress) since Q4 2006. It was largely expected, however; economists expected 2.5%; the actual figure was 2.6%. Also helping GDP was a partial reversal of Q2′s huge bounce in imports (33.5% annual growth rate) to an annual pace of 17.4%, and that helps the final factor in the equation below.
Output = Consumption + Government + Investment + Net Exports
All was not well, however, as the Chicago Fed’s National Activity Index, which has a very high correlation to future economic activity, weakened from August. Also, while the headline Durable Goods Orders grew far better than expected (3.3% v. 2.0% ) and better than August (-1.3%), the non-transports, non-defense–i.e. core orders–were disappointing, falling by (-)0.6% versus August’s 4.1%. Core orders is the best measure we have of capital spending, so those figures were not encouraging. The Chicago Purchasing Managers Index came out better than expected (60.6 v. 58.0), and some key components of the survey went in the right direction.
- New Orders jumped from 61.4 to 65.0 (read that as 65% of respondents said new orders had increased.)
- Employment moved up from 53.4 to 54.6.
- Production increased from 64.3 to 69.8
- Prices Paid rocketed from 55.0 to 68.9, welcome news for the deflation-focused Fed
Big week ahead with Nonfarm Payrolls report on tap
Key indicators to watch (in order of importance)
- Nonfarm Payrolls (October) – Friday - always the month’s most important
- Unemployment Rate – (October) – Friday – none other figure more important than J0e 70%
- ADP Employment Change (October) – Wednesday – as an augury of the biggie
- FOMC Rate Decision – Wednesday
- Initial Jobless Claims (weekly) – Thursday
- ISM Manufacturing (October) – Monday
- ISM Service Sector (October) – Wednesday
- Personal Income, Spending, and Savings