While we have generally disagreed with Morgan Stanley's Adam Parker flipflopping on stocks some two years ago, or just as the market was topping out, we can't find fault with his latest note released today in which he openly admits that "our portfolio advice has been pretty horrendous lately. As my 90-year old Latin teacher used to tell the class in 1985, “son, you are in left field, without a glove, with the sun in your eyes."
For those who follow our portfolio, we did quite well over the five years from 2011-2015. But, our portfolio just had its worst month in 61 months in January, and things have not improved in February. The market is down more than we thought it would be. Our biggest sector bet has been financials (particularly credit cards). As an investor recently said to us at a conference, “I am doing a lot of things, just nothing with confidence”. Doing the opposite of what we recommended would have been better. Bizarro World. Or at least hopefully not the real world.
Why has said advice been horrendous? In three words, blame "bizarro world." Here's why:
Martin Marietta reported last week, and they and a couple of other materials companies have blamed their poor quarters on the rain. Even Milli Vanilli’s success with this line turned out to be fake. The rain? Oh, the stock went up a lot that day. Bizarro World. The credit card companies are discounting a consumer recession. The banks are discounting an industrials recession. But, Visa said volumes were good in January, and jobs, housing, delinquencies, confidence, and other metrics appear to belie the market price action. Bizarro World. Companies with good results are being hammered. Companies with bad results have stopped going down, with freight, WMT, and other prior losers outperforming. Bizarro World."
We truly find it amusing how increasingly more "serious people" allign with our cynical view of the "market", one in which nothing makes sense and merely reporting on day-to-day centrally-planned events, which have zero logical continuity or cause and effect, is grounds for constant entertainment.
What is Adam Parker's recommendation?
Are we on a cube-shaped planet? Should “Us do opposite of all Earthly things?” Everything seems backwards. Sell winners, buy losers, own staples in both up and down markets. Just do the opposite of what makes sense. Bizzaro World.
In other words, this:
No Adam, not Bizarro world world, a world taken over by central planners. And yes, even the most rigged markets can go down as well as up. Enjoy.
And we hope our readers enjoy some of the excerpts from Parker's full note because it is truly an amusing admission of just how broken everything is.
What are the other major client concerns?
China economy and currency devaluation: We are definitely concerned about the China economic slowdown and the tighter financial conditions that ensue from the currency depreciation. Morgan Stanley’s house view is that the depreciation will continue (6% more this year and 11% more through year-end 2017), and it is hard to argue this won’t continue to impact emerging markets and therefore demand for US exporters as these countries’ currencies weaken. From the US equity perspective, we are generally avoiding stocks with exposure to the Old Economy - no metals and mining, no materials, less than the benchweight in industrials, underweight energy. In our judgment clarity on the trajectory of the Chinese economy and stabilization in major economic factors seem like prerequisites to get backlog growth and higher book-to-bill ratios for the exposed US companies in industrials and technology. Among the items we are concerned about, after a slowdown in the US consumer, next on the list is further Chinese economic deceleration or currency depreciation.
Fed impotence: Many investors have been suggesting that the Fed and frankly all monetary policy makers globally have run out of power. There are roughly 15 countries with negative yields out seven years on the curve. So, investors are asking about monetary policy efficacy, cuts not hikes, the zero bound, and QE4. Is 4 bigger than infinity? It is definitely true that the bubble is in the belief in the policy makers. Investors are worried that US economic conditions need to really deteriorate for the Fed to admit the hike was wrong, so markets will likely continue to go lower if economic news is bad, and another group of investors worry that if the Fed acts, it won't be effective. We don't think lowering the front end to zero will be good for stocks. We do think a QE4 would be, or at least we won’t fight it. Last week we received an article about negative CORPORATE bond yields from an investor. That being forwarded to us just about summarizes where people’s heads are right now. In the end, Morgan Stanley’s economic base case is still slow economic growth and slow retrenchment from the Fed, but our judgment is that bad economic news won't be rewarded. We are not as concerned that the Fed will make a mistake in terms of raising the front end, but it is Bizarro World.
Earnings season and outlook: We had thought the EPS season would assuage fears that formed and grew in early January. The disturbing development is the price action this year, where the rewards for beating estimates has been small, and the penalty for missing has been harsh. This is new from last quarter, where there were high rewards for beating and big penalties for missing – but of similar magnitude. (Remember the Thursday night in October of last year when Amazon, Google, and Microsoft all beat expectations and collectively added roughly $100 billion of market capitalization before the open the next morning?) The big reward for beating expectations hasn’t continued this quarter. So, if beating isn’t rewarded and missing is punished – isn’t that also called a down market? EPS season in aggregate has been fine – 85% of the market cap has reported and there’s been 4.1% upside to the embedded consensus numbers, about average for the last 27 quarters, all of which have shown upside for the US market. Forward guidance has come down sharply, possibly a negative harbinger but also making 2016 expectations really low relative to history and potentially too low in absolute terms. The long-term average for the bottom-up estimates is for 14% growth at this time of year, and it is currently around 3% for this year. That seems pretty low to us. Earnings will end up about $118 in 2015, with $5 in energy. They were $119 with $13 in energy in 2014. The current consensus is $122 for 2016 with $2.30 in energy. So, there is a diminishing impact of the lower oil price. Moreover, earnings in 2015 grew around 6% ex-energy. Expectations don’t seem that high to us right now for the full year 2016. We are at $125.9 – above the bottom-up number, a place we have never been before at this time of the year.
The oil price...: We interpreted the energy sector news during this earnings season as worse for the oil price recovery in the short term. Why? Most of the big companies reporting aren’t really guiding for that much of a US production cut. Hess, Noble, Anadarko, and others are guiding to big capital spending cuts but to production being barely down. Anadarko would rather cut their dividend than more dramatically reduce production. Imagine if we told you 18 months ago that oil would be down 75%, the rig count would be down 75%, capital spending would be down 20%, and production would be relatively unchanged. Wow! The technology improvement has been massive. Exxon announced they will do a 25% capital spending reduction and will now only do $23.2 billion this year! That still seems like a huge number in absolute dollars.
Fixed income guys are smarter than equity guys: Personally, we are not quite as worried about this issue as others. Fixed income guys are always negative and many of them were advising SPX puts early in 2013. Nonetheless, they are now in all their glory, even if they will get paid less. There are frequent periods in the past where high yield and equity didn’t move in tandem (tights in 1997 and equity market peak in March of 2000). The energy patch obviously explains part of it (SMID-cap E&P are different from XOM). The consumer patch explains part of it (the companies that are growing OK have no debt or have investment grade debt). The financials are in far better condition than prior cycles. The fraction of corporate debt that is long-term relative to short-term is at an all-time high – companies took advantage of the market and termed out. Interest coverage (particularly ex-energy) is in WAY better shape (several turns higher) than prior cycles. So, maybe both equities and high yield will be correlated for now, but ultimately we resist the notion that we hear all the time (internally and externally) that the bond guys are much smarter than the equity guys and high yield leads. We are both equally wrong at times. Why did financial stocks in Europe seem to lead the financial credit in Europe?
Europe: for vacation but not for stocks? One thing we worry about is that US investors are not mentioning Europe very much as a risk . It seems odd to see the Euro Stoxx down 16% in local currency year to date (about 7% worse than the S&P500) and to also think people are pretty complacent about Europe. Investors have said to us lately, “I am worried that the US banks stocks are telling you the US is in big trouble economically," but they seem less worried that DB being down 54% (from its 52-week high) is a bad sign for Europe. In our meetings in the US the last few weeks, no investor asked about Europe as a risk factor. This reminds us of a year ago when no one was asking about China as a potential risk. When we articulated in our year-ahead outlook we preferred US to European equities, we had thought the US would be up 4% and Europe maybe just 1-2% this year. We did not envision a down 9% vs. a down 16% scenario.
Parker's conclusion: buy because, well, there is no reason to buy.
What’s the bull case? The positives are this: no one is articulating a bull case for US equities with conviction. Earnings expectations are potentially low. There is some fiscal stimulus this year (vs. drag previous years). The Presidential candidates don’t appear to be multiple expanders now, but they will get more centrist and the riffraff will be removed in a few more weeks. Sentiment is low (two weeks ago an investor on a panel we moderated said “It is a multi-variable world and every variable is negative”.) The US probably looks relatively better than other parts of the world. So maybe, the bull case is just that no one can articulate a bull case.
Or perhaps, just perphaps, if no bull case can be made, sell?