‘RIDING THE CROSSCURRENTS, ‘ by Jurrien Timmer, Dir. of Investment Research at Fidelity Investments. ‘…POTENTIAL FOR GOOD RELATIVE TRENDS COMING FROM EMERGING MARKETS & COMMODITIES.’ Half my portfolio is in E.Mkts. & Commodities!!!!!!

In Uncategorized on August 4, 2010 at 14:07

Riding the crosscurrents


U.S. stocks could stay in a sideways market. Consider emerging markets and commodities.

To say that the market has been confusing and frustrating could be the understatement of the year. U.S. stocks have gone nowhere this summer, but we have seen huge volatility and many head-fakes. There are just so many crosscurrents that it’s hard to know which end is up anymore. I think we could have a choppy, sideways market in U.S. stocks for some time. Two potentially bright spots, in my view: emerging market stocks and commodities.

U.S. stocks hit a near-term high April 26 that came without much of a warning from the technical indicators that I watch. Then we had the flash crash and the European debt crisis in early May, which sent U.S. stocks down sharply. They bounced back temporarily after the European Central Bank stepped in with a rescue plan. But then economic indicators in the U.S. turned negative in a big way, while at the same time it was becoming clear that the Fed was not waiting in the wings ready to pull the trigger on a second round of quantitative easing. And down the market went again.

Stocks whipsawed (as so often happens), then on July 1 we got what I think may well turn out to be a lasting bottom for stocks. Investor sentiment hit rock bottom at that low and many people fled the stock market. But by July 27, we were some 10% above the lows. The most recently released earnings news has been good. The European stress test was good (perhaps too good to be believed?). Now investors are playing catch-up. So, do we get the all clear? Not so fast.

The good news

With earnings season in full swing, many companies have not only beaten their earnings estimates, but also provided very positive future guidance. If the earnings are to be believed (though a recent McKinsey report suggests skepticism), then the S&P 500 500® Index (.SPX


) currently looks to be trading at only 11.5 times next year’s estimated earnings of $95 per share, and would yield over 8%. That’s huge compared to the current 6% yield on investment-grade corporates or the 3% yield on Treasuries.

I believe there are other classic signs of a bottom in stocks. Copper prices have risen, which has historically signaled strong economic growth and a rebound in stock prices. And other economically sensitive indicators have behaved positively lately, including the Bloomberg Financial Conditions Index (BFCI),1 risk spreads, and crude oil.

Europe seems to be getting better, having apparently passed the stress test. The euro is up 12 points from its low of 1.18 on June 7. Sovereign risk spreads for Greece, Spain, and other European countries with debt problems are down. Their bond auctions have been well received by investors, and even the stubborn LIBOR-OIS2 spread, a measure of risk in the banking system, is now starting to come down.

With the euro up, the dollar has recently been declining, which in my opinion is often a good sign, for it suggests reflation and global growth. Emerging market stocks have outperformed the U.S. recently. Just look at the above chart of the MSCI Emerging Markets index3 versus the S&P 500 overlaid against the dollar.

Trouble spots

But there are trouble spots, too. The Economic Cycle Research Institute’s Weekly Leading Index (WLI)4 has now dropped from +26% in late April to -10% through the end of July on a year-over-year basis (see graph below). Sure, the WLI is driven by financial factors and can therefore turn on a dime. Nevertheless, every time the index has declined to -10% in the past, a recession has followed (the index began in 1967).

Similarly, J.P. Morgan’s Economic Activity Surprise Index (EASI)5 is at levels usually seen during recessions (see graph below). This index compares actual economic reports to the estimated numbers and gives us a sense of how good or bad the econonic momentum is. It’s pretty bad right now. In fact, it’s as bad as 2008 and 2001. Both were recessions.

Why is the economy slowing?  I think the economic recovery last year was driven (among other things) by two factors: a build-up in the inventory cycle and the stimulus bill. The direct effects of the stimulus bill are now running out and the inventory cycle seems to have peaked. Meanwhile, in Europe, we have the PIIGS (Portugal, Italy, Ireland, Greece, and Spain) crisis, and in China, we have a government-engineered slowdown.

As I have written before (read “A fork in the road for markets?”), I believe the market needs either positive economic momentum or monetary and/or fiscal stimulus (or preferably both) to rally. Right now it is getting neither. In my opinion, this may be why the stock market is down.

Which brings me to the Fed. During his recent testimony before Congress, Fed Chairman Ben Bernanke said that the Fed is concerned about downside risks to its otherwise bullish outlook (of 3% to 4% GDP growth in the coming years), but then went on to explain in detail all the ways that the Fed could shrink its balance sheet. Yet when he was asked about further stimulus, he said those options had not yet been reviewed.

This tells me the Fed may not be mentally prepared to re-stimulate if the need arises. If the Fed is wrong about growth and is not in a mindset to re-stimulate, then it could fall behind the curve if the economy does relapse. This is why gold has been weak, in my opinion. Gold needs the prospect of money printing to rally, and that prospect now seems further removed than before.

As for Europe’s stress test, I think it all seems a little too good to be true, given that only the banks’ trading books were considered and that the “haircuts” that were applied on sovereign debt holdings were quite small. Another negative sign about economic growth comes from the bond market. While I think it is bullish that credit spreads are not widening, I think it is not bullish that the 10-year Treasury yield remains around 3% and that the two-year yield remains at an all-time low of 0.62% (below even the 2008 crisis levels).

Finally, regarding companies reporting stellar earnings, I wonder how reliable that is as an indicator. A study published in the McKinsey Quarterly6 in April shows that analysts tend to be too bullish about the future. So, perhaps the bulls are clinging to a false hope when they point to company earnings?

A repeat of the first half of 2008?

I think the trillion-dollar question remains this: Is this merely an economic slowdown, as the bottom-up evidence suggests, or the start of a new recession, as some of the macro indicators suggest? It has been my long-held thesis that it is the former, but there is no denying some of the bearish indicators.

Coming back to the crosscurrents—economic strength versus weakness, and inflation versus deflation—what if we have a little of each? What if this conflicting set of indicators tells us that we will have growth, but that the growth is happening not in the U.S. and Europe, but in the emerging markets? And that while deflation rules in the U.S., inflation rules in the emerging markets?

Strong growth coming out of Asia and other emerging markets could explain the strength in copper and oil, and to a certain degree the strength in earnings and guidance. It could also explain the weak dollar. At the same time, the poor showing in the Economic Cycle Research Institute’s WLI and J.P. Morgan’s EASI indexes could be telling us that the U.S. is stuck in a malaise, with neither growth nor stimulus to bail us out. After all, the inventory cycle has petered out, the stimulus has run out, the housing market is going nowhere fast, companies appear loath to spend their hoards of cash on labor, the banks are not lending and consumers are not borrowing, and the unemployment rate remains stuck at high levels.

My sense is that globally this is just a slowdown, but that it is masked by weaker growth in the U.S. and stronger growth in emerging markets. I think the first half of 2008 is a suitable analogue. Back then the U.S. was in recession and stocks were sliding, but the emerging markets were booming and commodities were soaring. What if we get a replay of this scenario in the months ahead, perhaps until the mid-term election? It could happen, and if so mean that we could have both deflation and inflation at the same time — deflation from credit, housing, unemployment, and services, but goods inflation exported to us from China and elsewhere.

That kind of scenario could really put the Fed in a bind. It may not be able to tighten because the U.S. economy is too fragile, and it won’t be able to ease further. Add to this the Tea Party movement and its potential effects on the mid-term elections in terms of fiscal austerity, and the periodic flashes of general antigrowth rhetoric coming out of Washington, and I think there may be a real malaise brewing here.

What would that mean for stocks? In my opinion, that could suggest a sideways, choppy market in the U.S. but with the potential for good relative trends coming from emerging markets and commodities.


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