Submitted by The Contrary Investor
A View From The Corner Office(s)
We are all quite aware of the fact that heightened volatility has become a short term norm in the financial markets as of late. Not surprisingly, we’re seeing the same thing in a number of recent economic surveys. The most current poster child example being the Philly Fed survey that has shown us historic month over month whipsaw movement over the last few months. Movement measured in standard deviation parameters has been breathtaking. All part of a “new normal” in volatility? For now, yes.
But over the very short term economic surveys and stats have been taking a back seat in driving investor behavior and decision making in deference to the “promise” of ever more money printing. Of course this time the central bank wizardry will happen across the pond, although the US Fed is also now back to carrying out it’s own modest permanent open market operations (money printing) relatively quietly, but consistently, as of late. Although over the short term “money makes the world go ‘round”, we need to remember that historic money printing in the US in recent years only acted to offset asset value contraction in the financial sector and did not lead to macro credit cycle acceleration engendering meaningful aggregate demand and GDP expansion. And we should expect a Euro money printing experience to be different? Seriously?
We forgot where we originally saw this important quote we believe attributable to Ned Davis. The markets trend on fundamentals, but trade on technicals. Personally, we believe this is clearly applicable and very important to our current circumstances. Equity markets over the recent past have both anticipated and discounted meaningful intervention by the Euro powers that be, yet as of this writing with no explicit or detailed plan for debt reconciliation. As of the week ended the 20th, we’ve blown past key Fibonnacci levels to the upside like a hot knife through butter. The rally has produced the first trip above the 50 day moving average for the S&P since late July. Relative strength and MACD formations are looking much more positive on both the daily and longer term charts. Technically, life is looking a whole lot better than it did three short weeks ago. Got it. So what about trend?
First, the glaring divergence of the moment is that credit markets have not followed the equity market lead at all. The last time we saw a divergence such as this was in late 2007 and into 2008. Not a fun time, but certainly not a guarantor of current period darkness to come. Rather, a key point of divergence to monitor. We need to remember that in the land of global credit markets there are no “freqs” (high frequency traders) running the show and gunning for quarter and half pennies throughout the day. The credit markets represent human decision making. Short term equity market movement much more reflects computerized algorithmic rhythm.
Secondly, the movement of leading economic indicators using the ECRI numbers continues south for now. Will the decline in price pressures as transmitted by the contraction in a number of real world commodity prices in recent months arrest this deterioration? Yet another key watch point for the world that lies directly in front of us.
To the point of this discussion, two sets of data never captured in economic stats, but we believe very important in terms of our trying to assemble the mosaic of leading fundamental tendencies are the two quarterly CEO and CFO surveys brought to us by the Conference Board and the Fuqua school/CFO magazine. Yes, we know they are “surveys” and not quantitative fact, so to speak. Yet as you look at the charts below, it’s clear that listening in to what “the corner office” has to say about life has been quite important to forward decision making over various market/economic cycles.
Below is the longer term history of the quarterly CEO survey. Important right now in that CEO confidence in the recent quarter has experienced quite the meaningful drop. In the top clip of the chart below we’re looking at the history of the survey with the red bars indicating prior period official US recessions. Important issue being this survey has dropped very sharply in front of each recession of the last three decades. We’ve never dropped below the 40 level on this survey without a subsequent and near term US recession occurring. We’re darn close right now.
The bottom clip of the chart is again the history of the CEO survey alongside the year over year change in real US GDP. You can see that similarity in historical rhythm is more than striking. But what is important is that key cycle turning point change in CEO optimism has preceded directional change in the real economy. There simply is no argument with consistency in leading tendency over the entire period shown. Message of the moment? As is self evident, the CEOs see softening.
Very quickly, look at how CEO optimism shot skyward with US money printing events (the Fed’s quantitative easing programs) in early 2009 and in the second half of 2010. So why aren’t they just as excited over a Euro area potential money blast? Have they learned the “real economy” lessons of monetary ease of the last three years? Have they learned that money printing so far has only offset financial sector asset contraction? It sure looks that way, doesn’t it? We’d suggest next quarter’s survey numbers will be a key tell.
Walking down the hallowed hall to the next “corner office”, how about thoughts from the CFO outpost? The chart below encompasses the history of the Duke Fuqua CFO optimism survey. The blue bars represent the percentage of CFOs more optimistic about the US economy compared to the prior quarter. In the current survey that number stood at 12%. Alternatively, those CFOs less optimistic about the US economy rose to 65%. As the top clip of the chart shows us, this is a very low level of optimism, only seen during the 2007-early 2009 period. At that time the CFOs were spot on. As the old market saw goes, “the CFO always knows”. And that’s exactly why we integrate this into our macro view of life.
Very quickly, the bottom clip of the chart above is a simple mathematical calculation. It’s the percentage of CFOs more optimistic about economic outcomes less the percentage less optimistic. “Net” optimism, if you will. Is the message of the present clear enough? Again, this is not about negativity, but rather listening to the message of those closest to the actual pulse of the real business environment. The message seems very consistent with their CEO compatriots down the hall – money printing is fun, but it will not necessarily translate into guaranteed real world economic expansion outcomes. Much bigger macro message? Don’t be fooled by the illusion that can be created by printed money.
A few final charts that very much speak for themselves. Important to our decision making is that the CFO contingent for now expects earnings growth to hold up in the high single digits. Not even close to the deterioration we saw in late 2008. But remember, as we look back we saw CFO earnings growth optimism shoot much higher as the Fed’s first quantitative easing program was announced in early 2009 and again in the third quarter of 2010. Not this time as we ponder a Euro sponsored money blast. The law of diminishing (money printing) returns? Sure could be.
As we have contended for years, nothing expresses confidence like actually opening one’s wallet and spending one’s precious financial resources. The bottom clip captures current period expected corporate capital spending plans from the vantage point of the CFO bird’s nest. Not total darkness, but less confident is the message de jour. And like the credit market message of the moment, it stands in contrast to recently newfound and short term equity market optimism.
Are two of the most senior corporate corner offices expressing to us doom and gloom? Not at all. They are expressing realism about fundamentals. They are expressing realism about actual fundamental “trend”. They are expressing to us that money printing is for show, but real world corporate and economic fundamentals are for dough. After investors and “freqs” are finished anticipating and digesting yet ever more money printing follies, trend will come into focus perhaps a bit more meaningfully than short term technicals. It’s all in the ebb and flow of perceptual focus and the dynamic of human decision making behavior.
One additional comment again driven by recent survey data. Throughout the current 2009 to present economic and financial market cycle, we have suggested that dividends within the context of total return investing would be a very important theme. Let’s end with some good news from the corner office(s). CFOs expect meaningful dividend increases ahead. As we see it, this clearly represents balance sheet and cash flow confidence. We’ll reiterate this one more time. Consistency and a focus on absolute rates of return is a key in the current environment. And that has little to nothing to do with central bank monetary machinations.
Summing all of this up, just what does this mean to our very near term investing activities? First, put the money printing “noise” and financial market volatility it creates into bigger picture context. Do not let it play havoc with your emotions. Keep focused on fundamental “trend” and look for opportunities in companies with strong balance sheets and consistency in cash flow that will allow them to create shareholder value within this challenging environment via wide moat franchises capable of delivering sustainable dividend growth, share repurchases and sensible and opportunistically financed global expansion activities.