The 2nd quarter is here, so it’s time for another Bull v. Bear entry. This edition focuses pretty squarely upon Q2 alone, since my long-term bull thesis remains (as I’ve found no new evidence to revoke it)…
- Inventories- Starting with the fringe, analysts are coming around to the idea of the US’s economic momentum sputtering out in Q2. The strong 1q13 seems to have been spillover from the slow YE12 (blame the fiscal cliff), and now the effect is waning. Nomura says that inventory accumulation contributed as much as 1.2pp to Q1’s 3.0% GDP forecast. I always track inventories, which are a good midstream economic indicator, and I’ve noticed that they’ve again reached that level of time-tested resistance, whereafter economic activity and the stock market pause to let consumers draw-down the stockpiles. To confirm inventories’ anecdote, consumer confidence and railtraffic have been slow this year too. This week, we opened Q2 with a continued decline in railroad cargo volumes, now at only +0.7% y/y, which meager growth won’t support GDP expectations nor an S&P 500 that’s +10% ytd.
- PMIs- March PMIs were just reported, and although the globe is still growing in aggregate, the devil is in the details: there’s a stark divergence between contracting developed markets (particularly Europe) and expanding emerging markets (specifically in Asia). Unfortunately, EMs account for only 12% of global market capitalization, and I’m most concerned about the US in these pages.
- Europe- Cyprus’ recent bail-in has brought the Eurocrisis back into headlines. France’s economic woes are worsening, and now the Netherlands is suffering a quiet housing crisis, which is evidence that the panic has penetrated the EU’s core. That’s also particularly bad for geopolitics, since the Dutch are one of Germany’s only allies to have pushed the hawkish austerity measures that’ve guided the rolling crisis thus far. In addition, seasonality suggests that it’s time for another EMU brush with disaster, as many Euro (EUR) analogues to prior calendar years can attest.
- Deflation- Commodity prices from Brent Crude to WTI to iron ore to corn to gold and silver have been plummeting alongside interest rates (like the 10y Treasury) for the past couple weeks. Even the 5y5y forward inflation (TIPS breakeven) has noticeably declined, now down to 2.50661%–the brink of concern. I noticed the start of this two weeks ago:
“A correlation analysis [between 5y5y & SPX] suggests we may be in the midst of a deflationary slide analogous to that of 2010-11… If 5y5y can hold around 2.50%, then the Fed has successfully managed price levels (half of its dual mandate–employment being the other). If 5y5y continues sliding lower, then the $85B/month flow from open-ended QE3+4 will likely be increased.”
- Valuations- SPX is fully valued, and it’s expensive–the combination of which certainly doesn’t mean it’s fairly valued. Let me explain this notion. Historically, if we take a long term average (10 or 15 years) of key valuation metrics, SPX is fairly valued. But, if we look at recent history (1, 3, or 5 years), it’s very rich. Put this within context of a 1.8% 10y or a 4.8% Baa yield, and a 7.3% forward earnings yield looks like a good deal–but you have to consider that secularly, multiple contraction has been highly correlated with disinflation. At the end of the day, both realized & implied volatility are low in the market. This also happens to be the second-most sentiment driven rally of alltime. Combine all that with a “not-inexpensive” market, and you have a very fragile situation, wherein intrinsic risk is actually quite high.
- Consensus- The sell side’s consensus is still extremely bearish, albeit improving. That’s a contrarian indicator, which means we should be bullish (“buy when others are afraid”).
- Guidance- Reduced guidance has set the bar really low for Q2 earnings, with 70% of reporting management teams having trimmed their targets for the quarter and many lowering FY13 expectations for a 3rd consecutive month. We’ve seen this chicanery throughout the recovery rally, as recently as 4q12, when 74% of companies beat their lowered guidance–and the market likes it.
- Seasonality- The last 3 spring seasons have met market corrections of at least 10%. This year, the mainstream media have picked up on the alliteration, which consciousness means the pattern should break this time around. It’s like the maxim “sell in May and go away” or the “January effect”; these patterns work until they don’t, and when they don’t work, it’s often because people frontrun them, flicking the risk-off switch in advance to catch the top. Depending on how many people take this same tactic, the market either undergoes a short, sharp swoon ahead of schedule, or the selling gets imperceptibly diffused due to high variability of market participants’ expectations. I expect the former in 2q13, for two reasons: First, (in reality) most of the spring swoons in recent history (2010 & 11) triggered near May, but the headlines haven’t analyzed the minutia of timing–instead they’ve lumped together the whole quarter, using Q2 as synecdoche (in perception) for the empirical spring swoon. Second, the whole world has been waiting to “buy the dip.”
- Lending- So far this year, credit demand has finally started increasing, and banks are finally starting to relax lending standards. All of the liquidity that the Fed & Treasury pumped into the banking system may finally start trickling into the real economy. For the first time since 2008, my group has started underwriting unsecured bank loans–whereas our extension of credit was contingent upon adequate collateral (liquid securities, real estate, or personal property) between 2009-12. Much of our competition has rolled out similar products this year too. However, loan demand, as far as I’ve seen, is tepid, as the primary excuse is “after I pay taxes.” I can attest: banks have substantial liquidity, “dry powder” that can redouble economic activity were it to be deployed. This is a huge ace-in-the-hole.
- SPX 2006 Analogue- The most reliable guide I could’ve asked for may warn that there’s a little downside left in the market near term, but the analogue also asserts that we’ll lift from a V-shaped bottom and rally into the summer months with risk-assets leading the way.
Overall, when I weigh these items in aggregate, I can envision the quarter ahead. The theme of a divergence in perception v. reality is laced throughout my analysis. There needs to be a recoupling there before this market can move forward, much like the fully priced market in September 2012:
“Currently, we’re in the ‘show me’ state (not to be confused with Missouri). This is a state in which the market seems fully valued, waiting for more information to push or pull it one way or another… It’s all about the future, what’s coming.”
Also like September’s environment, SPX has consolidated over this past month–the technical equivalent to the market’s body-language expressing fatigue. Today’s atmosphere isn’t an “all news is good news” bull cycle or “all news is bad news” bear. In consolidations, market participants approach news from a realist’s angle, discounting information at face value, and that news is what the market awaits to tell it where to turn next.
With sentiment catching-down to fundamentals, the recoupling of excited perception and lagging reality may pull SPX lower in the middle of April–chalked up to mere “earnings agita.” I’m not concerned by what little [ephemeral] downside may arise in the short term. Technically, the sheep will frontrun [a widely anticipated] spring swoon, their selling quickly lopping-off a couple-hundred Dow points, in accordance with the 2006 chart analogue discussed herein. That’s when Q1 earnings start trickling in. Not only was Q1 likely strong, but the bars for Q2 & FY13 have been set calculatingly low. Combine with a few upward revisions, 1q13 EPS hits and beats can reverse sentiment for the better. Just because SPX is fairly/fully valued doesn’t mean that it won’t push the envelope as psychology transcends excitement en route to thrill. Fundamentally, the macro resonance from a lending jumpstart and a participating consumer would be more than enough to trounce weak PMIs and deflation.
Base case is still for a shallow pullback giving way to a 5-6% SPX rally into the summer months.