Diary of a Financier

Bull v. Bear: Risk/reward edition

In Capital Markets on Fri 8 Feb 2013 at 18:06

I’m on the record as a high-conviction bull. Herein, I wanted to supplement my prior commentaries with some refreshed material that fortifies continued bullishness. I’ll start with the risks to my thesis, then I’ll discuss the upside rewards…

The Risk

The grey swans out there are everpresent: Eurocrisis, sequestration, etc. Black swans and “uncertainty” are always there too, but by definition there’s nothing we can do to predict or avoid them. (I try my best to preempt such shocks by studying history and psychology.) My focal points here today–the risks I’m capable of managing–are the US Earnings Recession, the Credit Cycle, and Inflation.

Starting with the threat of Earnings Recession, I see a few troublesome developments that warn of an EPS slowdown. As I’ve mentioned before, the lethal combination of record low wages, record high profits,¹ and record high corporate margins suggest that S&P 500 EPS had reached a mathematical limit. Accordingly, net margin growth dipped into the red in 3q12,SPX EPS composition- revenue v margin growth something that correlated to an economic recession 2 out of 3 occurrences in the past 20 years. 1997 was the only time the US averted a crisis after margin growth turned negative, but at that time the Greenspan Fed was stimulating the economy amidst the Asian Crisis (and LTCM thereafter). I obviously need to look at the context of the economic/market environment in order to qualify this kind of data. I’ll do just that in “The Reward” section below.

Moving right along, the credit cycle has crept into mainstream consciousness as bond spreads grow historically tight. I certainly worry about duration risk,² but I don’t worry about defaults. I think the credit cycle is only in its 6th inning for the following reasons:

  1. Spreads– Tight absolute & relative spreads make sense given the duration risk of high quality paper. I don’t love buying B- paper at a 550bp spread, but such High Yield trades with a duration of 4. The market has braced itself for rising rates, and if rates do rise, that’s a lot better place to be than TIPS with a duration of 5.6, Munis at 6.7, Emerging Market Debt at 6.8, or 10y Treasury at 9.1. By comparison, US HY at a 550bp spread with 6.7y avg maturity vs. Sovereign EM at 270bps and 11 years (Corporate EM @ 370bps). With those specs, I’ll bid HY over EMD; no contest.³
  2. Commercial Mortgage Backed Securities– As of 4q12, the smart money had just started buying CMBS, having been crowded out of the non-Agency MBS space by hedge funds that arrived late to the game.
  3. Securitization– The first major CLO deals since 2008 were just priced in 3q/4q12, and one of the first post-crisis subprime CDOs I’ve heard of is being assembled now too. At this rate of issuance, these are stalwarts of an optimistic market, far preceding euphoria.
  4. Corporate Leverage– Currently 1.7x, which is the historical average vs. modern peaks of 2.1 & 2.3 (in 2002 & 2009).
  5. Loan Quality– In January, loan demand increased, and lending standards were loosened for consumer credit, auto loans, and prime real estate. While subprime standards continued to tighten, the loosening in other categories confirm a bullish trend that just began after 4-5 years worth of retrenchment–a mid-cycle, recovery-esque signal.

Then there’s inflation, an arrow in a lot of bears’ quivers for the past 5 years. An oft-cited barometer is oil, which currently trades up at a “lofty” $96 (Brent $119). 5y5y forward inflation (TIPS breakeven)Perhaps more relevant, the Fed’s favorite indicator is 5y5y forward inflation (TIPS breakeven), a market-derived inflation forecast for the period 5-10 years out from today. 5y5y ended 2012 with a high reading of 2.904%, pushing the 3% ceiling that’s always capped expectations. Ventures higher have been discouraged by either hawkish Fed intervention or another mean-reverting catalyst. True to form, 5y5y pulled back from that upper limit to end January back down at 2.58%–right within the Fed’s desired range. Realized inflation has been even milder, with Headline CPI running at a 1.74% clip. I don’t see a risk here either.

I seem to have dispelled all of these risks, but like I said, these are the risks I’m capable of managing. Thus, I’ll continue to monitor them as they mature.

The Reward

I don’t think there’s much equivocation in the inflation argument: the environment is perfectly moderate. In addition, both Headline & Core CPI are at their lowest sustained levels since the mid-1960s. The following graph illustrates asset class returns given different inflation environments. It’s clear that we’re currently in a low inflation environment, defined as < 3.3%, for which equities outperform all comers–regardless of inflation’s subsequent trend. My base case expects +20% average return in equities, as displayed in the graph’s lower left quadrant (“Low and Rising Inflation”). In fact, the only scenario in which equities do not outperform is shown in the top left quadrant (“High and Rising Inflation”):

Asset class returns in different inflation environments

In addition, 2013 is the 5th year of the bull market that began in March 2009. In the postwar era, there have been 12 bull markets. 8 lasted at least 4 years; the remaining 5 lasted even longer. Of those 5 bull markets that sustained a 5th year, the average return was +19%. The 3 markets that failed in their 5th year happened to have crashed. This looks like a real binary precedent, however all 3 of the failures entered their 5th year with rich valuations (FwPEs of 16x, 20x & 22x), whereas SPX entered 2013 with a Forward PE of 12.5x (now 14x). Given that context, this provides another bullish base case.

That brings us back around to fundamentals and the question of an Earnings Recession. What rescues us from the brink? Well, durable goods spending has been remarkably weak. The average age of durable goods is at an alltime high, with the average automobile 4.25 years old (by far an alltime high) and the average appliance 5 years old (barely exceeding the record from mid-1990s). Durable goods spending vs SPX EPSDurable goods spending has barely recovered from its crisis low, and at 20% of GDP, it’s running far below the 25.3% postwar average. Further, 9 of 10 SPX corrections have occured with durable goods spending >24%–a far cry from today’s levels.

The state of durable goods says two things to me. First, they’re a meaningful component of economic growth. Second, a small oscillation in durable goods will move the needle in EPS and GDP. Therein lies potential for SPX revenue growth to outpace margin contraction. I look at this like an opportunity to buy a space wherein there’s been a pricing distortion and psychological overreaction. After all, consumers have deleveraged, with household debt service/income at 10.4% (the lowest level in 30 years). Hence, my position in Ford (F).

Finally, two other pillars constituted the integrity of my bull foundation year to date. The first was the 2006 SPX analogue. My last note suggested SPY would rally another +3% to $151 trendline resistance of a long term rising wedge. SPY did just that, then it paused at the end of last week and battled to bust through that ceiling, which it accomplished today. It’s now melting up to resistance of its long term bull channel (>$152):

SPY daily

SPY daily

Henceforth, the path forward has already been written by the 2006 analogue:

I now expect a parabolic spike higher in SPX over the longer term, due largely to the bullish SPY 2006 monthly analogue… Starting in January 2006, SPY rallied +24% over 21 months to squeak out a new alltime high. There was only one correction along the way (-7.83% starting May 2006) before a parabolic rally to the heavens ensued. Today, a similar percentage rally would take SPY up over $182–well clear of its alltime high at $157.52 (+7.25%). But, I care not to speculate on the magnitude and longevity of the forthcoming move.

Second, I ran that quantitative analysis of overbought markets, which yielded a screaming buy signal.

We’re just about 70/30 with a 0.89 beta to SPX… extremely bullish compared to our 60/40 benchmark’s 0.76 beta. SPY indicators have almost confirmed a reversal out of nasty bear divergences across daily, weekly, and monthly fractals. That development would send this market into a vertical assault a la 2006.

–Romeo (hattip David Kelly & Thomas Lee, J.P. Morgan)

¹Record low wages and record high profits are both as a percent of US GDP

²Our 30% fixed income allocation is comprised of non-Agency MBS, High Yield & Floating Rate Bank Loans–all low duration.

³Aside from currency risk, rising real interest rates in the developed world really threaten capital flows to the emerging markets, which is why EM yields are so low in the first place; particularly vulnerable (in order): China, Brazil, Indonesia, Korea, Poland & Columbia.  Those countries’ FX will take a brutal hit, which is why nobody should own local EM bonds ($EMLC).

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