Tuesday, February 14, 2012

2012 Non-Predictions - Equities

Well TMM must apologise for their laziness this year in getting their Non-Predictions out. To be honest, we have found it pretty hard to get excited about anything: the backdrop since the beginning of the year of improving data, particularly in the US, sitting uncomfortably aside continuing Eurobllx is unchanged. TMM really have run out of ways of writing the same thing over and over... what can we say? Please Mr. Market, can we have something new to get our teeth into? Anyway, we managed to drag our sorry arses out of our lethargy and do some work.So TMM present, embarrassingly late, their 2012 Equity Non-Predictions.

1) EM Equities will NOT repeat 2011's under-performance of DM Equities.

Last year, TMM judged the worsening inflation picture in Emerging Markets and associated tightening would prove challenging for EM Equities, and the mid-year spike in risk aversion dealt an even bigger blow to the asset class as cross-border equity flows reversed for two consecutive quarters - an event not seen since 2008. But TMM reckon that the picture looks a bit better than prices would perhaps reflect, even accounting for the large move higher seen since the beginning of the year. TMM hold that EM equities are rarely a trade on "the next big thing" and whenever they hear market participants begin to talk about "decoupling", large alarm bells go off in their heads. Instead, TMM reckon that EM/DM relative equity performance is driven by a combination of relative growth, inflation & money supply growth, as well as the global inventory cycle. The last of these - despite both the gallant attempts of the BRIC crowd and Europe-bears to argue otherwise - seems to be purely driven by the US.

Using this basic framework, TMM have been able to describe a good part of market moves (see below chart). In 2007-8, the Great EM Decoupling Experiment first led to very strong EM out-performance, before the inevitable global linkages branded this experiment a complete failure, as EM equity markets crashed, playing catch up to their DM cousins. While the fit is not perfect, since mid-2009, the model has basically come back into line with performance, except for the past six months - driven, as noted above, by cross-border repatriation spurred by Euro-break up fears. But in recent months, TMM judge the EM growth/inflation mix to have improved significantly, as base effects left over from the Arab Spring and momentum in food prices wane and the US inventory cycle spurs renewed production (and export growth) in Asia. And even though EM equities have put in a sterling performance this year, TMM's model would suggest the out-performance has further to go.

TMM were lucky to catch most of the move up in H-Shares in January but are now flat, hoping for a pull-back in order to reset such trades expressing this theme.

2) Equity Bears will NOT stop trying to argue that earnings will fall as a result of margins contracting from multi-year peaks, but S&P earnings growth will NOT disappoint the consensus of 5.5%.

If TMM had a Pound for every time they have heard the argument that earnings have to fall as a result of margins peaking from multi-year peaks, they would have little need to stay in the hedge fund business. The trouble with this argument is that (i) TMM have been hearing it for many years (which, admittedly, does not mean it is wrong), and (ii) certainly over the past 15 years, TMM reckon the evidence suggests that it is the economic cycle rather than margins that determine whether earnings fall or not. The below chart shows TMM's naive earnings model which uses ISM, input/output prices, corporate financing costs, wages & the Dollar to try and explain earnings growth. The model missed the 1998/9 Russia/LTCM-driven fall in financials' earnings (i.e. - not having a financial crisis-type variable in it to explain investment bank losses), but largely appears to do a reasonable job. So TMM's point here is that if you are looking for earnings to fall, then it's going to come from either another financial crisis (probably in Europe) or a double dip back into recession.

As readers know, TMM reckon the US recovery now has exit velocity, so they judge the latter as being unlikely. Regarding the former, TMM have noted before that it is entirely rational for markets to price in the very large tail risk emanating from Europe, but they cannot be fixated by it permanently. We judge a good deal of the global de-rating in the latter half of 2011 as being related to that, but as time passes and (hopefully) growth returns to Europe, that risk premia will be taken out, sending the S&P500 from the 12-13x earnings range to the 13-14x range. For the time being, the strategy of buying dips in the S&P seems the right one.

3) The ASX 200 will NOT reverse its poor relative performance and will remain a laggard of global equity markets.

This particular Non-Prediction is related to one of TMM's rates Non-Predictions: "The RBA will NOT cut more than 25bps and the Cash Rate will also NOT finish 2012 below its current level of 4.25%". Last week's RBA decision seemingly confirms the reluctance of the RBA to cut, and with the currency sitting close to multi-decade highs it is clear that monetary conditions in Australia are relatively tight. This is not surprising to TMM as, one of their ex-colleagues one surmised, the RBA care first about China, second about the global environment (i.e. - Europe, right now) and last about Australia. Sorry, TMM will correct themselves - they care about Australia *second to last*, with New Zealand occupying the last slot. But cheap jokes aside, the anecdotes regarding the potential hollowing out of the domestic economy by the mining sector - i.e. Dutch Disease - are not to be ignored.

The trouble is, that these effects tend to take years to play out in their entirety - for example, witness the crowding out of both the domestic & export sectors that high financial sector Terms of Trade in the UK managed over the past decade. It took many years for the over-valued Pound to eventually collapse. That experience (TMM tried shorting Betty repeatedly between 2005 & 2008 to no avail) forced TMM to look elsewhere. If you think the domestic economy is getting smashed, then you need to trade something linked to the domestic economy. The closest liquid proxy seems to be the ASX. It is not perfect as still close to 30% of its weighing is materials/energy, and whether true or not, the perceived link to China could well give it a lift should the Chinese economy roar back above trend again. TMM haven't completely figured out their implementation here, but would assume that selling ASX vs. US/Japanese equities and buying calls on Chinese H-Shares could be one good way of playing this.

And with that, TMM will wish their readers a Happy Valentine's Day.


Amplitudeinthehouse said...

ASX trade : Big lesson learn 2011,when there's an overvalued currency in the wings , the relative Index is the way to go..DAX.

Since we've just seen today how the world is going YENNISH!(F*CK ME!)

Steve said...

Great earnings chart guys. I'm going to ponder it.

Anonymous said...

TMM, do you use any software for your modelling? SPSS maybe?

Anonymous said...

Overall, I agree, but am going to be a bit of a pedant. You say your model doesn't account for the dip in earnings in 1998 because it doesn't include a financial shock variable.

How then does it explain the gigantic losses among financials in 2007-2008?

Intrinsic said...

Just with regards shorting Aussie economy proxy, hows the crude method of short ASX and long weighted commodity names in the index?

So for every dollar short ASX, long 30% BHP, RIO and WPL or any combination that makes up for the commodity weight of the index.

Off to run some numbers but just want some thoughts from TMM

Anonymous said...

Cdn lumber sales to China declined 36% in December. Weakening construction?

"B.C. lumber sales to China falling rapidly". http://www.theglobeandmail.com/report-on-business

cpmppi said...

Anon @ 7.35pm,

We use excel and some home-written stuff. Haven't seen SPSS... will take a look.

Anon @ 9.56pm,

Two different types of financial shock - the 98/99 crisis had little effect upon the economy as losses were concentrated at investment banks. The 2007/8 experience was a generalised economic shock and therefore the model seemed to pick that up. Though if you look closely at the chart, the model missed the very beginning of this as financials began writedowns in late 2007, but the real economic weakness did not become particularly apparent in the data until Q1 2008. Adding in a financial crisis variable would probably pick this up better, but I'm too lazy! ;-)

Yeah, can't see much of a problem with that - most of TMM cannot do single names, hence our pondering.

Amplitudeinthehouse said...

Last seen on the front door of NOMURA FX dealing room.


WellRed said...

AAPL was due, but this is pretty violent.

abee crombie said...

margins will come in when 1) interest rates go up (maybe in my lifetime) 2) employment slack weakens. Hard to see either over next few years

re AUD, short auzzie banks?

I'm still not 100% sold on EM outperformance. EM stock markets still titled to basic materials/oils/national champions etc which I dont have a strong opinion either way on. Consumer stocks and others are expensive. but lets see. Frontier markets eating dirt so far, lagging big time

Leftback said...

Lots of really good stuff here. Still chewing through it, but here goes (apologies for long-windedness):

1) EM v DM. Not sure. This is really dependent on two things: Chinese growth and the dollar. If events elsewhere conspire to allow the dollar to appreciate, then the flood of hot money from the US to the EMs will certainly be stemmed. Since much of that flow is based on US "inflation fear", a modest or pronounced global slowdown would certainly stop that trade dead in its tracks. What worries LB about China is the fact that some measures of what is going on in China (electricity demand) aren't as growthy as the Official Government Number Generator would suggest. As for Brazil and Russia, they are obviously commodity plays and highly vulnerable to the above. TMM always seem to see more inflation than LB but that is b/c you sit in London at the very epicenter of Mervynflation.

2) I agree completely with TMM that the proposed margin squeeze is NOT happening (mainly b/c US employment based costs are essentially flat). I do not necessarily agree that earnings will grow at 5.5%. The problem with TMM's US earnings projections is that although Henry and Henrietta Hedgie are still shopping on Greenwich Avenue, the lower rungs of US society frequented by LB are still struggling. Joe Sixpack's wages are flat and he is already feeling the effects of higher gasoline prices that are approaching those of last Spring.

2012 January gasoline was the highest ever, and a large slice of the US economic landscape is on a tight budget and extremely sensitive to $gaso. Expect to see this reflected in demand destruction, lower demand for gasoline and disappointing retail numbers (both may already be happening). Earnings for domestic energy companies and retailers may start to reflect this before long.

As for US reaching escape velocity, TMM may have been smoking some rolled-up government statistics and not looking at the bottomless pit of US housing market with its endless foreclosure backlog and associated markdowns. Bernanke has announced a state of ZIRP, baby..... Japan has yet to escape from ZIRP.

3) Agree completely. I like this one the best.

ASX faces a variety of potential and perhaps some unavoidable headwinds. Any slowing in China hits the miners hard. Firmer dollar and resulting unwind of AUDUSD carry will also hit commodities and commodity currencies hard. Finally, an acceleration of the downward movement in Aussie housing prices has the potential to cause severe weakness in Aussie bank stocks. Once the meltdown starts...

As we have seen last summer, as go the banks, so goes the index. Follow the leverage and some great potential shorts may be out there. Of course when discussing Australia, one must also remember that HOUSING NEVER GOES DOWN, there is a SHORTAGE OF LAND, and IT CAN'T HAPPEN HERE.

Anonymous said...

India food inflation is coming down, so RBI may lower rates, but that will also slide the rupee(harder for borrowers to pay back loans denominated in $), but good for biz.

Anonymous said...

"TMM reckon the US recovery now has exit velocity"

It is quite serious statement. What do you call exit velocity? Do you mean US returning to the averages between 80s and 00s? or 80s and 07? Same GDP growth, unemployment rates, budget deficit, and fed rates? When will we get to that? In six months or a year? How will we get there? Cut in budget? Increases in taxes? Which taxes, individual or corporate? How you see real personal disposable income growth? What are the sources of it, ex-transfers? How would it fit into "non-decrease in margins"?

Sorry for these many questions, but i think this prediction is the most critical. It would be really great if you can elaborate on it.

Leftback said...

US small business isn't drinking the Kool Aid. It's not really government regulation, they just don't see an increase in demand.

Gallup Small Business Hiring Poll

Leftback said...

US small business isn't drinking the Kool Aid. It's not really government regulation, they just don't see an increase in demand.

Gallup Small Business Hiring Poll

Leftback said...

Hmm... 3-day US weekend approaching. Is it just me or were people buying T bills early today?

We are looking for some eager punters to take a few riskier equities and junk bonds off our hands today.