Friday, September 02, 2011

Tayloring a Pantomime Bear

As TMM noted yesterday, a new month brings new appetite to shoot for one's favourite trades, and given that most folks still view the past week's bounce as primarily the result of month-end re-balancing (whether flattered by expectations of Fed easing or otherwise), the default response is to "sell". The TMM IB sentiment meter is still firmly entrenched in bear-mode, with not even a reasonable ISM print able to turn things around, with many using the spike as an opportunity to sell against the 50% Retracement level of the SPX move down from late-July to mid-August. Indeed, this morning, there is no shortage of emails in TMM's inboxes expressing the view that "even if payrolls do surprise to the upside, risk won't be able to rally" and the sheer glee with which punters IB-blasted "*DJ Troika Suspends Greece Inspection Visit" accompanied by bellicose statements relating to the fact that Greece is a mess, and the periphery is a mess, but carefully ignoring to report the later *GREEK EU-IMF REVIEW `NOT SUSPENDED', GREEK OFFICIAL. TMM once again ask "But is that REALLY 'new' news?". Of course not: the European situation is, at best, a muddle through and it is hard to credibly argue that anyone was expecting anything but negative news-flow to emanate from the region. TMM are nonplussed.

Back to the ISM data. TMM have learned over the years that punters never let the facts get in the way of a "great" trade, and yesterday was no different, with bears arguing that even though data surprised to the upside, the trend is down and therefore "down we go". The trouble with this view is that ISM does not point to a recession, and even though there has been a sharp bounce in equity markets, they are still pricing a material probability of either recession or a permanently lower-P/E ratio. Now, to the first point, assuming the consensus are correct with respect to next week's Non-Manufacturing ISM print, TMM's survey-based model would imply GDP growing at around a 1.75% annualised rate (see chart below). Not great, and certainly below stall speed but under such a scenario, earnings are certainly not going to be falling. The blended 12m EPS forecast on Bloomberg of $107.88 for the S&P500 implies just under 17% earnings growth, but even if one assumes something more conservative like 9% EPS growth would put the S&P500 at 1313 with the current P/E of 13.17.

To the second point, TMM have more sympathy. The recent volatility in both financial markets and in macroeconomic volatility have certainly lowered the "fair value" for the valuation multiple in recent months. And while P/E models based upon macroeconomic and financial inputs are highly sensitive to the regression period, for the record, TMM's version (see chart below) is pointing to a multiple over the next 6months of around 12.3x, which would put the S&P500 at something like 1285 (using the blended past 6months/forward 6months EPS). And if applied purely to trailing earnings (i.e. - assuming zero earnings growth, something that appears very unlikely given the above growth points) would still only put the index at 1125. Of course, should volatility fall - something that TMM expect given policymaker actions both at national and supranational levels - then this macro model-implied P/E ratio will move higher again. TMM thus find it very hard to argue that the market is anything other than cheap and, at worst, only slightly overvalued.

And now, to a final point. TMM are often greeted with the statement that if the data is bad that means we're going into recession, but if the data is good that means there won't be any QE3. The trouble with this argument is that the actual reality is far more subtle. To see this, think about what a Taylor Rule actually means in qualitative terms: it tells you what the policy rate should be based upon the inflation gap and the output gap. In English, that means "If growth is below trend, then policy should be eased provided inflation allows it". The worrying point, in this respect has been that core CPI has been rising. However, this is likely to peak this month as the low base effect from last year's deflation scare drops out of the calculation. Regardless of overshoots in both directions and base-effects, a simple old-fashioned output gap model (see chart below, brown line) of core-CPI (white line) has been pretty good at getting the broad trend in core inflation right since the mid-1990s. To the first point, the "good" data still implies below-trend growth, and unless the data improves to the point of implying 3% growth, then orthodoxy would imply that monetary policy should be loosened to offset the widening of the output gap. Simply put, unless the data is *very* strong, QE3 is coming.

And with that, TMM wish their US cousins an enjoyable weekend but not before leaving you with TMM's analysis of the NFP numbers later today.

P.S. - And finally, TMM must extend their heartfelt sympathies and best wishes for a speedy recovery to MacroMan who, we have just been informed, has blown apart his Anterior Cruciate Ligament in his OTHER knee.

19 comments:

Anonymous said...

'C from C'
says' we don't know what is being priced in although it's nice to think that we know. We also don't know whether equity is cheap ,or overpriced ,but gain it's nice to think that we know. Indeed when I think about all of the things that we don't know I wonder why anyone would pay us for not knowing these thngs ;)

I'm not sure i have seen a market where you couldn;t go away and come back with some charts and a plaudsile rational why you should arrive at some particular conclusion ,but I try not to fool myself that this counts for much.

On the otherhand my intuition tells me either nibble shortside ,or stand aside until something clearer comes along.As it stands I don't have a "rational" in pictures or anythingelse that I would want to put weight behind.

Anonymous said...

'C from C'
should also say the more numbers and the more analysis the more I am inclined to think someone is trying hard to convince themselves that they do KNOW something ...LOL

Anonymous said...

'C from C'
my analysis,price is going down because people have long weekend and want to go for a beer without wondering which Euro politician is going to spill his guts this weekend ,as we know there is always next week.

Anonymous said...

'C from C'
says' .In fairness my more intuitive feel is not radically different to your. I was looking for a range right here sufficiently wide to capture both the optimism and pessimism that is coming our way via the Euro issue.
If I am intuitively right we can go sideways in this range for at least as long as we went sideways in the higher range during which views on pricing of equity should not be radically different for either camp. Caveat is the Eurozone can with a blunder blow this apart.

SirArthur said...

By almost any measure US and European equities are cheap, and any short trade would have to be just that - a short term trade.

Problem I'm having with everything is that I can still see no solution to the Euro sovereign funding issue.

Also contrary to posts in the comments section, I don't believe there is any form of political master plan to fix the Euro-zone. In fact the only person "in charge" seems to be Mr T who is about to exit stage left.

The reflexive nature of the Euro crisis (ie markets selling off making the situation worse still) and the fact that any whiff of a breakup will cause a run on the banks; banks which are interwoven with all the other banks as it were, makes me think that the potential for a very unpleasant outcome is still high...

Secret-Sauce said...

"Cheap by any measures"?!? Sold to you!

btw, is that $107.88 firm or indicative?

Anonymous said...

'C from C' says'
I can't even remember how many times I've heard all this before,"cheap" and then "cheap" got "cheaper" and "cheaper" as the look over the shoulder at earnings gave way to looking in front at the difficulties being unfolded for business and they are mounting.
No offence, but models suck unless you have an extremely strong stomach ,and or a cash cow that keeps topping up your ability to buy better price opportunties.

It's a sad ,but sorry truism that large sentiment change can blow the best earnings model so far out of the water it is meaningless. Personally rather than anchor on something like "cheap" I tend to put it in my back office until I can find the right time to bring it out again otherwise we end up buying 'Northern Rocks' ;)

Anonymous said...

Sorry, I may be ignorant!

9% Unemployment - arn't 91% still working?

What's the obession with numbers?

Too much govt. intervention all over the world. Do those bureaucrats have something else to do?

Let the markets be FREE!

Anonymous said...

http://www.frbsf.org/publications/economics/letter/2011/el2011-26.html

P.P. Mazzini said...

EPS estimates assume record high margins will continue to infinity. My bet is that margins will revert to the mean. Sooner or later labour will regain a modicum of negotiating power via trade measures against China as a result of political populism.

Ambointhehouse said...

Don't know if this is going overboard in regard to extrapolation but can you post post QE apples v likely QE apples with your qualitative numbers vs say June 2010.....did we hit those targets,how far off\over.....guessing pretty good chance it happen, but what "percentages" did we have to climb?

Alen Mattich said...

Oooh, bad luck Mr Macro. I'm hoping it wasn't another skiing accident. That'd be pretty embarrassing in August. Best wishes to him if he's reading.

I vote with P.P. Mazzini. Margins are at record highs, thanks to massive volumes of fiscal stimulus plus zero interest rates. Not only is the fiscal stimulus evaporating, but governments are going to look to fund themselves from where the money is. Which, these days, is bankers and companies.

Cyclically adjusted P/Es are still about a third overvalued for the U.S. while Tobin Q says they're 40% to 50% overvalued.

Jeremy Grantham figures were in for a long decline in equity prices. Who am I to disagree?

Anonymous said...

No matter how great your model is when your investments have to rely on the competence of politicians and politicians alone it takes a strong stomach to put down your cash.

The fact that the brand politicians currently at the wheel are the best possible option, certainly in America, scares the crap out of me.

Polemic said...

Anon 2.27 That made me smile .. Very apt. Sounds like flower prints and happy thought economics ! we need some of that. Its all a bit depressing as Anon 9.27pm depressingly summarised it. Yup we can number up all sorts of stuff we like but all it takes is some dick head politico to screw it all up.


C from C .. you must have had a long tea break around 11 ish and then lunchtime .. With that sort comment indulgence ( for which of course we thank you) you'll have us wondering what your regular pursuit is. Of course you are right "cheap" is a rubbish term but there have t obe SOME comparatives to work with.. Or perhaps as you say that is the problem. Why mess around with comparative values if the whole lot is about to tank. But I don think it is all gong to tank and even if it does and we go through some paper money/debt/ holocaust, when i get up in the morning I d rather own a chunk of a factory that made something that folks need than a bond drawable on nothing or a piece of shiny metal that i assume is in a warehouse 3000 miles away. That reminds me, I should check McDonalds share price.

the baby boomers selling their shares story is interesting but hardly relevant to the next 3 months. And , just a thought .. If the baby boomers all sell yet earnings in these companies stay the same .. dont their dividend yieldsgo higher? ( which i assume would suck in overseas non western investors?

Messrs Mazzini and Mattich

Yes, makes total sense .. but as a non equity expert can you tell me why all these blindingly obvious future vs past disconnects ( such as margins wont stay high forever) are not acted on by equity professionals? I would have thought the forward functions you describe should already be in the price or is the equity market really that populated with EBITDroids who only look backwards?

abee crombie said...

Hahahha. It's quite a confusing time. Seems like zh bloggers have taken over tmm. My only problem with cheap argument is that it's the msfts and hpqs that are cheap. Mega large cap with some lt problems. Mid and small caps run the range on valuation ... Some cheap some still trading at 10x ebitda.

It's easy to be bearish when the news is bad. But it's knowing when to buy, I think, is when the real $$$ is made.

I mean why be so negative on stocks. Is it the companies fault they are making $$.. I agree that markets are very very unstable. Hft is bad for stability. Govt policies suck balls... Europe sovereigns are a mess.. But don't hate the stock market for that. Companies are just doing what they do. I really see a multi year bull market starting soon. Valuations and sentiment are ripe. I only really worry about inflation not zh bloggers and the end of the world.

Alen Mattich said...

Polemic,

This has puzzled me for a long time: Why equity investors are willing to ignore fundamentals for such long periods.

My guess is that equity investing is a bit of a cult, where faith outweighs facts and there are charlatans at every corner willing to take advantage of them.

Because so much of the market is driven by people whose interest is turnover and because turnover generates the best fees at high prices, there is an institutional incentive to keep boosting shares. Marginal investors, the guys who set the price, tend to be amateurs (including long only fund managers) who are heavily influenced by recent price action and recent history. And recent history tells them that equities tend to go up and when they don't central banks intervene.

Amateur psychology, I know, but that's how I see it.

History also shows that buildups of leverage tend to inflate asset valuations and deleveraging tends to go in the opposite direction. It takes a while for this to sink in. So the downside risk to my bear case (that the market goes up, up and away) is that somehow central banks kickstart another leverage boom. They'd need to convince people inflation is going to race away and so far the bond markets suggest that the last possibility (though, for what it's worth, I agree with Albert Edwards that the last act of this play sees a return to Weimar economics).

As for margins tending to revert to the mean, but people not acting on it, well, I suppose expectations are always weighted to the status quo. In other words, people think that this time things might be different, or that we've witnessed a step change.

Finally, as one old hack explained to me when I started off, bond markets are full of people who think, equity markets are for people who go to church.

When looking at the current state of the economy, I side with the 2% 10-year Treasury rather than the near 1200 S&P 500.

vlade said...

I have to say I don't understand why people see the ISM number as "good".
The numbers higher on the print than before were:
- inventories. I doubt increasing inventories are good for economic growth...
- new orders. Would be encouraging, if it wasn't that it was "falling slower than before" (but still falling) rather than rising. Also, the reading is 0.4 better, which IMO is within the statistical error.
- backlog. See above
- supplier deliveries. Stat error margin.
- customer inventories. Customer inventories rising - I'd say that's a sign of end demand slowing. Surely again not a great positive for the economy?
- imports quite higher. I'll admit I don't know what imports exactly stand here for, but somehow I don't think it's a huge plus for the economy either.

Overall, I'd say at best neutral picture on the above.

On the negative numbers, most of them dropped by quite a bit.
- prices paid - drop by almost 4 points. That's quite a bit, and again, doesn't indicate any sort of final demand strenght
- production. - again, 4 point drop, moving from + to - teritory. Ouch.
- Employment. Down by almost two points. Probably above stat error, but not much. But after the previous read dropped 6 points, it's not encouraging development (on Fri, manufacturing jobs were -3k).
- New export orders. Drop of 3.5, and just above the mid-mark (by stat error I'd say, so it could as easily be below). With readings like these, US is not going export it's way out of the problem.

Overall, this is I'd say a negative picture. Not massively, depression-here-we-come negative, but watch-out-for-downside definitely.

Combined, I'd not call the numbers good, unless you look only at the final print.

PP Mazzini said...

I believe that the reference to a Zero Hedge "crazy" was directed at me. If you'd like to set aside your prejudices, here is a bit more support for the argument about declining margins, or is Albert Edwards a Zero Hedge "crazy" also?

PP Mazzini

PP Mazzini said...

Here is the link that I intended to attach:

http://www.businessinsider.com/albert-edwards-says-its-time-to-stiffen-up-the-sinews-summon-up-the-blood-and-gird-your-loins-2011-9