"This Time It's Different?" - David Rosenberg Explains The Melt Up And The Latent Risks
The market is ripping. That much is obvious. What some may have forgotten however, is that it ripped in the beginning of 2011... and in the beginning of 2010: in other words, what we are getting is not just deja vu (all on the back of massive central bank intervention time after time), but double deja vu. The end results, however, by year end in both those cases was less than spectacular. In fact, in an attempt to convince readers that this time it is different, Reuters came out yesterday with an article titled, you guessed it, "This Time It's Different" which contains the following verbiage: "bursts of optimism have sown false hope before... Today there is a cautious hope that perhaps this time it's different." (this article was penned by the inhouse spin master, Stella Dawson, who had a rather prominent appearance here.) So the trillions in excess electronic liquidity provided by everyone but the Fed (constrained in an election year) is different than the liquidity provided by the Fed? Got it. Of course, there are those who will bite, and buy the propaganda, and stocks. For everyone else, here is a rundown from David Rosenberg explaining why stocks continue to move near-vertically higher, and what the latent risks continue to be.
UP, UP AND AWAY!
It has been quite a move up in the U.S. equity markets. The S&P 500 just completed its fifth straight week of gains, the longest streak of the year. From the closing low of last October 3rd, the index has rallied a breathtaking 28%. So far in 2012, the Dow is up 8%, the S&P 500 is up 12% and the Nasdaq is up 17%. Breathtaking to say the least.
What accounts for all this optimism:
- The European LTRO program has obliterated financial tail risks in the region.
- The successful second bailout of Greece.
- Chinese inflation down to 3.2% has fuelled hopes of monetary ease.
- Perceptions that that the U.S. economy is reaccelerating — all the Fed had to do was change "modest" to "moderate" (plus the ECRI leading index has improved to a seven-month high).
- Tentative signs that the secular headwinds are subsiding — housing, credit, employment, local government fiscal restraint.
- Oil prices stabilizing with a calm emerging with respect to Iran.
- Technically, the market is making higher highs and higher lows — a confirmed uptrend.
- Global earnings estimates are no longer going down.
- Financial conditions are easing with corporate bond spreads narrowing sharply.
- The success evident in the Fed's latest banking sector stress tests — bank
- stocks advanced 9% last week.
- The snapback after the early-March triple-digit decline in the Dow — the first of the year has emboldened the 'buy the dip' psychology.
What are the risks?
That we wake up some time in the second quarter and discover that the economy may well have contracted if not for the extremely warm weather we had in the opening months of the year, which provided a huge, if not unprecedented, skew to the data (see Weather Alert: Why the Sun Could Be Bad for Risky Assets on page 14 of the weekend FT).
Remember —January and February were both 5 degrees warmer than usual. For months usually beset by winter weather, the seasonal factors attempt to correct for this by boosting the raw data, which at that time of year are about the lowest given that many folks are snowbound. If not for the seasonal adjustment process, we would only be able to compare the data on a year-to-year basis because there is no apples-to-apples comparison between economic activity in January and what you would typically see in May. So in January and February in particular, the raw nonseasonally adjusted basis get a "bell curve" like we would in school in a tough mid-term exam. The problem this time is that January and February were downright balmy. This wreaked havoc on all the data, especially housing, employment and spending.
We estimate that over 40% of the job gains were weather-related, taking both months into account. We also know that productivity is contracting and 100% of the time in the past decade, companies responded by curbing their hiring. So taking the weather effect into account and the reversal this will have in coming months with respect to the data impact, combined with the likely cooling-off in hiring plans already evident in many surveys, and we could well see the nonfarm payroll numbers get cut in half and come in closer to 100k than 200k as we move into the spring and summer months.
This is not a disaster story at all, but recall that it was this sort of sluggish backdrop that brought at least a temporary end to the equity market rally last year and forced the Fed into more intervention in support of the bond market. Don't write off QE3 just yet. On top of all that, we do expect to see the trade deficit continue to widen as the European recession and Asian slowdown hit the U.S. shores, and contraction in net exports is going to very likely emerge as a big headwind for the GDP data in the next few quarters. In fact, it is only now starting.
And by the time it subsides later this year, households and businesses will be preparing for next year's massive tax grab. If logic prevails, this preparation is probably going to include a move to boost savings and raise liquidity (ostensibly at the expense of spending growth — expect the retailers to head into the 2012 holiday season lean and mean).
The weather also had a direct impact on spending by releasing more than $30 billion in recent months in terms of household cash flow from a radically lower utility bill. Absent that de facto tax cut', and retail sales would have stagnated over the past three months as opposed to rising at what appears to be a healthy 8% annual rate. This will subside now and we have not yet seen the full brunt of $4 gasoline either — many a commentator has stated that the consumer sector is less vulnerable now and there is less of a "shock factor" this time around. We shall see about that.
As it stands, nominal spending at the pumps is at its lowest level since last June — we have not seen the draining impact on household cash flows yet. But we did see the impact on University of Michigan consumer sentiment, which surprised to the downside in a month that saw the Nasdaq head to 12-year highs and employment rip by more than 200k — going from 75.3 on sentiment to 74.3 is largely explained from the rise in gasoline prices.
The IBD/TIPP economic optimism index also slumped to 47.5 in March from the one-year high of 49.4 in February. The components of the recently released March survey data from NY Fed Empire and Philly Fed looked on the soft side, especially order books and production plans. This has also shown up in a recent reversal in President Obama's approval ratings — so the gasoline impact, with a lag, is only now starting to rear its ugly head.
Keep in mind that even with WTI consolidating, the prices that consumers pay at the pump are on a steady march higher — up 31 cents in the past month to an average of $3.82 a gallon (nationwide) — but already nearly one-third of Americans are paying $4 or higher. What does this then do to the GDP price deflator and hence to real growth — well, just have a look and see what happened in the first quarter of 2011. It's called stall speed, not escape velocity.
It is unclear just how stable things are in Europe. The ECB has papered over the problems for now but has jeopardized the sanctity of its balance sheet at the same time. The U.K. is seemingly on the precipice of losing its AAA rating status. Then we have Asia. India in a full-blown economic downturn and its banking system is in disarray. And the Chinese economy is now slowing down at a pace we have not seen since the 2009 hard landing. As the U.S. market has been surging, the MSCI China index sagged 2.7% in March —not a constructive signpost for the commodity complex. While this has caused the TSX index to lag the S&P 500, the Canadian dollar has managed to stay above par, in part because the rate-hike that is now being priced into the local bond market (Canadian 2-year note yields now offer a hefty 90 basis point premium to the U.S. comparable).
Back to China for a minute — the country's A shares are down 3.3% in the past month while the H shares have gained 18%. The Chinese stock market now trades at a 9.9x forward multiple, versus a 15-year average of 12x. So the market there is well valued and the A shares (those listed in China; the H shares trade in Hong Kong) may well be poised to play some catch-up here. Something we have noticed and are definitely keying on.
As for the overall market, our CIO, Bill Webb, likes what he sees in the form of the lingering wide gap between the prevailing return on capital and the cost of capital. Screening for GARP (Growth at a Reasonable Price) and yield remains in vogue. While we are involved in those slices of the market, the major averages have managed to rally to levels above the year-end targets the consensus established at the start of 2012 (of 1,355 on the S&P 500), as was the case this time last year. The S&P 500 has actually risen as much in 2012 so far as it did at this stage in 1998 and when you consider how benevolent 1998 was in terms of fiscal, monetary and economic stability just three years after the advent of the Internet, how can anyone really compare the two years?
What we are seeing unfold really is a liquidity-induced rally that is built on a lot of hope. Neither were required in 1998 — the Fed kept a neutral policy in place for most of that year and there was no need for hope; the growth in the economy was organic and self-sustaining without unprecedented government assistance. Even then, we had a near-20% correction that summer. Nothing moves in a straight line indefinitely and while Bill and the investment team have been tactically bullish for most of this year, we are feeling the need to dial back the risk somewhat near-term given the high levels of complacency and the fact that valuation is less compelling than it was four-six months ago.
For example, the FT cites research showing that the S&P 500 is now two standard deviations above its 50-day moving average, which is far beyond the norm of even an overbought market and in the past this has proven to be a pretty good 'chill for now indicator. Breadth has also deteriorated of late as the market has scaled new highs, which is often a technical sign that an intermediate top is at hand.
In the name of being 'tactical' and 'nimble', which is critical in today's rapid-fire volatile backdrop, getting a little more defensive here is not a bad idea at all. We also remain long-term bulls on gold and commodities, but with the U.S. dollar breaking out and the Chinese data coming in softer than expected for the most part, we have taken on a less ebullient posture for the time being and plan to get more involved at better pricing levels once this corrective phase runs its course. The mining stocks have broken below key support levels here and over the near-term, the chart points are to be respected.
Also keep an eye on the bond market, which has become a bit unglued in recent weeks. Of course, this happens at least four times a year so hiccups like this are really par for the course. And as usual, we are hearing once again how we should all be prepared for the end of the secular bull market in Treasuries. These Wall Street reports come out at least once per year, the latest coming from UBS strategists. When will these people ever learn? In any event, it has been a rocky road as the 10-year note yield spiked 27 basis points last week to a five-month high of 2.3%. This is all part of the global risk-on trade because German bunds sold off just as much, and other assets that tend to do better in risk-off environments, such as gold, also suffered setbacks (the yellow metal lost S50/oz over the week).
Bond yields are not yet at a level to upset the equity market apple cart, especially with the yield on the banks improving so much in one fell swoop. But if we approach 3% on the 10-year note then we could start to see the stock market pay some attention — it's not so much the level, as the change, and at a time when gasoline prices start to really pinch the consumer (driving season is right around the corner), rising borrowing costs are not going to provide a very constructive backdrop.
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