Fwd: Stock Market Observations July 1, 2013
Josh Whitcraft
Begin forwarded message:
Date: July 1, 2013, 11:23:40 AM EDT
To: "Craig Drill" <cdr...@cdccorp.com>
Subject: Stock Market Observations July 1, 2013
CRAIG DRILL CAPITAL
724 FIFTH AVENUE
NEW YORK 10019
STOCK MARKET OBSERVATIONS
Craig A. Drill
July 1, 2013
The Sell-Off
June had the largest volatility shock to government bonds in 20 years and the worst investment grade bond returns in 40 years. Gold appeared to be in a give-up stage, with the worst quarterly performance in 100 years. Equities in China were down 15%, followed by Europe down 6% and Japan, 5%. Copper was down 7% and corn 4%. In currencies, the Brazilian real was 8% weaker and the Indian rupee, 6%.
Like summer thunderstorms, corrections in bull markets come on fast and furious. Even if you carry an umbrella, you may get wet.
In fact, the umbrella can turn into a lightning rod. This happened with some value-at-risk (VAR) funds, which were long bonds to protect their long positions in stocks. In this recent sell-off, however, both bonds and stocks declined. In panics, the correlation of all longer duration assets can approach parity, regardless of their previous relationships.
These corrections remind speculators that markets are a two-way street. Injecting some volatility and uncertainty into capital markets, and curbing speculative pricing before it lasts too long, actually creates a healthier base for future markets.
The Stock Market
The US stock market seems to be in a zone of fair value. The price/earnings multiple of the S&P 500 Index is below 15 times the top-down investment strategists’ consensus operating earnings estimate of $108 for 2013 and $115 for 2014. This compares with a 50-year average of 15 times, but that 50-year span saw the 10-year Treasury note yield an average of 6.7% compared with 2.5% today.
Looking ahead, the equity market’s valuation should be protected by a continued friendly monetary policy and continued Federal Reserve balance sheet expansion. The market should grind moderately higher with a combination of earnings per share growth of 5% and a dividend yield of 2%. This total return should be attractive relative to fixed income securities.
Bottom-up, however, second quarter earnings could be disappointing. Corporate earnings are vulnerable given poor revenue growth and peak profit margins.
Investor optimism about America prevails: its manufacturing Renaissance, energy sustainability, innovation in science and technology, rule of law, and stable reserve currency vis-à-vis the rest of the world. The competitive position of the US is particularly improving due to the lowest relative wages in over a decade and cheap energy costs.
The Economy
The US economy continues to grow slowly compared with our post-World War II recession recovery standards. The annual growth rate for 2013 is estimated to be similar to what it has been since the end of the Great Recession in mid-2009, in the neighborhood of a meager 2%.
Unit data, such as the number of rail carloads of industrial products crossing the nation or containers passing through the Port of Los Angeles, are still below their 2006-2007 levels. Although the unemployment rate has declined by 2.4% from its peak of 10% in October 2009, much of this decline reflects a decline in the labor force participation rate of 1.5%.
Yet, there is no imminent risk of a recession as was feared a year ago. What the expansion lacks in strength, it may make up for in length.
Fiscal Policy
A fairly typical cyclical recovery is occurring in construction, motor vehicles and consumer durable goods. This growing momentum in the private sector, however, is flying into the significant headwinds of more stringent fiscal policy. The Congressional Budget Office estimates that this fiscal restraint is taking 1.75% away from nominal GDP growth this year.
Both the White House and Congress are focusing on reducing budget deficits. By sometime in 2014, the US will have largely disengaged from Afghanistan, as it has already from Iraq. Freed from two long and costly wars, the US is cutting conventional military spending to levels not seen since 2002. The cuts now focus on headcount; there is not much juice left in hardware.
Another round of across-the-board spending cuts (a second "sequester") is likely to commence in October. Fiscal Year 2014 spending caps under the Budget Control Act of 2011 will require more than $91 billion in cuts in defense and non-defense appropriations bills. These would be larger than the sequester cuts now in place for FY2013.
The Treasury's use of "extraordinary measures" to continue to pay down the nation's debt will be exhausted in late October or early November, precipitating another debt ceiling confrontation in Congress. The net result for already anemic business spending, especially in defense-related sectors, suggests more policy uncertainty ahead.
Major initiatives in Congress to reform our Byzantine tax code will face serious ideological and special interest push-backs. As a result, substantial uncertainty about tax policies continues to inhibit both individual and corporate decisions.
Monetary Policy
Meanwhile, with monetary policy, all the discussion is about reducing the historically aggressive stimulus at some point, not increasing it. The unwinding of quantitative ease will not be easy and will have consequences.
Chairman Ben S. Bernanke was undoubtedly shocked and dismayed by the market swoon in reaction to his hint that pennies from heaven may not fall forever. The combination of a badly mispriced set of fixed income securities, joined with leverage on those securities, explains much of the damaged done.
In his press conference, Chairman Bernanke reiterated that the $85 billion-a-month bond-buying program will begin to moderate, and eventually end, at such time when the unemployment rate falls to an indicated level of 7% (down from the current 7.6%) in a context of price stability. Despite such tapering, the Federal Reserve’s gargantuan balance sheet will continue to expand for some time.
He also affirmed that the federal funds rate will be held near zero until the unemployment rate has fallen to a threshold of at least 6.5% or below. This is contingent upon the core personal consumption expenditures deflator being no more than 2.5% (up from the current 1.05%). This is a data-dependent, not date-dependent strategy that will be hard to undo, even under a new Chairman.
Short-Term Interest Rates
For market participants, this means short-term interest rates will remain near zero for what might feel like an eternity. This has the potential to create mini-bubbles.
When short-term interest rates eventually rise, the stock market may do better, especially in the first year, because it will indicate a healthier economy. Like a runner, the faster he goes, the higher the pulse rate.
Global Capital Markets
Globally, we need to watch the unfolding of the Japanese growth strategy and the impact on its bond bubble and debt financing, as Japan has a debt-to-GDP ratio of 200%. In the US, policy was aimed at preventing deflation; in Japan, policy is trying to uproot deep and debilitating actual deflation.
In China, the focus remains on its credit bubble and its “on again/off again” liquidity squeezes. In the euro-zone, near-term the risks are with Slovenia and long-term with France. Politics can also suddenly burst out in unexpected ways, as we saw in Brazil, Turkey, and the Arab Spring.
The Bottom Line
The bottom line is that we will not be returning any time soon to the days of yesteryear, no matter how remembered. Too many things have changed, including ourselves. In modern, developed countries, strong economic growth depends on strong growth in credit…which is another way of saying strong growth in debt.
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