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It's been a stunning rally, but where do we go from here? My thoughts on fine-tuning a strategy for 2012
02/21/2012 8:30 am EST
I ended 2011 and started 2012 saying that I thought the first half of 2012 would be scarily volatile and investors should keep their powder dry for a second half rally after the People’s Bank cut interest rates. Wrong as of seven weeks into 2012.
About two weeks ago I opined that the rally now underway would run through February 29—when the European Central Bank offered European banks another 1 trillion euros in loans. Until then, I said it was safe to play the rally. After that, the odds of a correction would increase. Do I still think that?
Let me give you my take on where we are now and what moves are most likely to result in good returns with a reasonable amount of risk.
The U.S. market has turned in a stunning beginning of the year rally. The Standard & Poor’s 500 Stock Index had returned 8.56% for 2012 as of Friday, February 17. The small company stock Russell 2000 Index has crushed even that return. For the year that index is up 11.97% through February 17.
The rally isn’t limited to U.S. markets either. The iShares MSCI Brazil Index ETF (EWZ) is up 19.78% for 2012 through February 17. The iShares FTSE China 25 Index ETF (FXI) is up 15.46% for 2012.
Hey, even the European and Japanese markets are up big time year-to-date. The iShares MSCI EAFE Index ETF (EFA), which has 85% of its portfolio in Europe and Japan, is up 10.07% for 2012 through February 17.
In other words, this rally has been worldwide. Which, it turns out, offers some pretty important clues for why the market has behaved as it has so far in 2012.
First, we’ve had a re-run of the risk-on trade that formed half of the risk-on/risk-off pattern that dominated 2011. In the beginning of 2012, investors felt comfortable taking on more risk because the two big dangers left over from 2011 seem less threatening.
First, Europe seems less likely to blow up. As I post this, it looks like European finance ministers have reached a deal on Greece, but that deal doesn’t mean that the Greek crisis was resolved, fixed, solved, or whatever. In fact during the last few weeks European politicians have practiced a degree of brinkmanship that is truly scary. A Greek default in March has seemed a careless word or a misplaced decimal point away. (For my take on what would happen if Greece defaulted, see my post http://jubakpicks.com/2012/02/17/what-would-happen-if-greece-defaulted-and-left-the-euro/ )
But the rally wasn’t really premised on a Greece deal ending the crisis but on a reduction in the scope of the damage threatened by the crisis. The huge 489 billion euro in three-year loans extended by the European Central Bank in December to European banks and the prospect of as much as another 1 trillion euros in lending in a second facility on February 29 made it far less likely, in the market’s opinion, that a Greek default would take down the European banking system and that the unexpected failure of a European bank or two would blow up a systemically important bank somewhere else (such as in the United States.) A market that’s worried about the end of the world has a pretty low threshold for good news.
Second, the global economy seems less likely to sink into a recession. Sure, Europe is headed there, but the U.S. economy grew by 2.8% in the fourth quarter of 2011 and the Federal Reserve has promised to keep interest rates at their current extraordinarily low level through the end of 2014. Other central banks have unleashed their own stimulus packages on the world economy. The Banco Central do Brasil has been cutting interest rates since August. The People’s Bank of China lowered reserve requirements again just last Saturday, February 18. The Bank of Japan announced an expansion of its plan to purchase debt instruments. And then there’s all the money that the European Central Bank has pumped into the EuroZone economies with its purchase of Italian and Spanish government debt and its bank lending facility. There’s no guarantee that this river of cash will stop the slowdown in the world economy short of real pain, but growth prospects in both the United States and Brazil improved in recent government numbers and in China it’s increasingly clear that the government has embarked on a policy of monetary stimulus.
I think that’s a reasonable explanation for why global stock markets have rallied so dramatically in 2012 to date.
But what we’re interested in now is not the why of where the stock market has been but the why of where the stock market may be headed.
Of course, no one knows what will happen in the remainder of 2012. Will official U.S. unemployment sink to 7.8% by June? Will the spike to 4.5% inflation in China in January turn out to be, as I believe, a side effect of the timing of Lunar New Year in 2012 or does it signal a revival of inflation that will derail an interest rate cut in June or July? Will New Democracy win an unexpectedly big majority in the April election in Greece and repudiate the recently negotiated austerity package? I don’t know and no one does with absolute certainty.
What we can do as investors though to assess, to the best of our ability, what the market now anticipates—what is baked into stock prices. And assess, to the best of our ability, the odds that what the market anticipates will actually occur.
So, for example, the U.S. and global stock markets are anticipating, in my opinion, accelerating growth in the U.S. economy. That’s much more optimistic than the Federal Reserve’s forecast for the U.S. economy. On Wednesday February 15 the Fed lowered its estimate for U.S. GDP growth in 2012 to 2.2%-2.7%. That’s down from a November estimate of 2.5%-2.9% for 2012. The reading from the Organization for Economic Cooperation and Development, on the other hand, is more mixed—which is good news. In December the developed economies’ think tank upgraded growth prospects for Japan and the United States, but downgraded growth prospects for China, Brazil, and the EuroZone economies.
How much growth is the stock market anticipating from the United States? Somewhere between an acceleration from 2.8% to the heights projected by International Strategy and Investment, a forecasting firm that employs respected Wall Street economists Ed Hyman and Dick Rippe. ISI reads recent data on initial claims for unemployment and retail sales as pointing to 4.4% GDP growth in the first quarter. My advice is to watch Wall Street economists carefully. If more of them start talking about 3.5% or better growth in the quarter that would be good for stocks in the short-term, but raise the risk of a disappointment when we actually get first quarter GDP numbers in April.
GDP growth doesn’t translate into earnings growth in any straightforward way. And it’s the earnings picture that worries me most about the U.S. stock market. Earnings growth for the companies in the S&P 500 index that have reported as of February 17 show just 6.7% earnings growth. (Take out Apple’s blow-out quarter, Barclays Capital notes, and the earnings growth rate for the S&P 500 stocks falls to 2.9%.) Add in estimates from the S&P companies that haven’t reported yet and the growth rate climbs to 9.2%, according to Thomson Reuters. The percentage of companies beating Wall Street earnings projections, again according to Thomson Reuters, is just 64%, well below the historical average of 70% positive surprises for a quarter.
And the earnings picture could be getting weaker as we go into 2012. The estimated earnings growth rate for the S&P 500 in the first quarter of 2012 is just 2.2% year-to-year and for second quarter the projection is for just 8.3% annualized growth.
The culprit seems to be declining margins. I don’t think there’s anything surprising here. The global and U.S. economy is growing just fast enough to put pressure on supply and nudge prices for raw materials higher, but growing just slow enough to make it hard to pass all the raw materials increases on to customer. I’ve seen exactly that comment in conference calls for companies as different as McDonald’s (MCD) and DuPont (DD) recently. A margin problem of this sort comes to an end either when growth picks up enough so that companies can pass on increases in raw materials costs (That’s a process called “inflation”—remember it?) or growth declines enough to take pressure off supply.
We are, however, near the end of earnings season for another quarter and Wall Street and investors tend to pay less attention to earnings at this time in the quarterly cycle. In other words, the earnings picture might not look good and might be setting up the market for a disappointment but Wall Street managers and investors might be quite willing to overlook earnings data right now.
That’s especially true because everyone’s eyes seem focused on central banks and the wonderful magic they practice by waving their magic wands at money supply. I can’t remember a moment when all the world’s central banks were so busy expanding money supply—absent a clear-cut global crisis such as the Lehman bankruptcy. And there’s no immediate sign that the money supply party is about to end. The European Central Bank is projected to unleash another 1 trillion in three-year lending to European banks. The People’s Bank of China continues to ease, as is evidenced by Saturday’s cut in the reserves that China’s biggest banks need to keep on reserve. That’s good for adding a little more than $60 billion to China’s money supply. And the Federal Reserve has promised to keep short-term rates near 0% until the end of 2014.
As long as central banks keep pumping money into the financial markets and real economies—and as long as investors keep their faith in the magical powers of central banks—this by itself is probably enough to keep asset prices (that is, stock markets, rising).
So what could go wrong? Two things I think.
First, one of the central banks that the market is counting on to support asset prices could raise fears that it wasn’t about to come through. The bank I’d watch here is the People’s Bank of China. I believe that the 4.5% increase in inflation, a big spike up for December’s 4.1% rate, is a result of the move of the Lunar New Year holiday from February in 2011 to January this year. The Lunar New Year holiday always plays havoc with year-to-year comparisons because consumers and businesses shift so much spending around in the weeks before the holiday. But I could be wrong. If February inflation is also up at 4.5% (or, horrors, even higher) that would raise fears that the Bank of China isn’t going to keep cutting the reserve ratio and isn’t going to cut interest rates in June or July. That could send China’s stocks (and quite probably those of Brazil and other China dependent exporters) into a correction.
Second, events could rattle the market’s faith in the magical powers of central banks. Remember that not so long ago investors had reservations about the effectiveness of monetary policy (pushing on a string) and the impossibility of intervening in Spain and Italy because they are so big. Now, however, with the U.S. economy apparently accelerating and Spanish and Italian bond yields falling, central banks can do no wrong.
What could shake that conviction? Dare I say Greece? And I’ve got my worries about the Federal Reserve too.
Greece could wind up shaking faith in central banks again. Not this month and not in March. This go round looks likely to end with another agreement and another payment to prevent a Greek default on March 20.
We don’t know yet what the schedule is for future payments under any Greek rescue agreement will be but if this agreement follows the form of previous agreements, the money will be parceled out in three-month stages. After March comes June, if I’m counting correctly.
That’s enough time for the Greek economy to contract even faster than expected—which would blow a hole in this most recent agreement big enough to lead the troika of the International Monetary Fund, the European Central Bank, and the European Union to refuse to pay out more cash unless Greece cut its budget again. By that time, Greece will have a newly elected government headed, in all probability by Antonis Samaras, who was making noises about renegotiating the deal before it was signed and before he was elected. Looks like another replay of the current Greek crisis with every player even closer to just walking away.
And by that time, it’s quite possible that the recessions in Portugal, Spain, and Italy will have thrown doubt on the assertion from German Chancellor Angela Merkel that Greece is a unique problem. If the European Central Bank can’t stop the run on Italian and Spanish bonds that would ensue, then investors will start doubting central banks again.
And then there’s the Fed question. The Fed had been trying to bring down long-term interest rates, the part of the yield curve over which it has very little direct control, with relatively limited success—until the Greek debt crisis provided a big boost. With investors looking for safety, they snapped up U.S. Treasuries and sent yields downward.
But what happens to the Fed’s success if the financial markets are convinced—for a while—that the Greek crisis is over and it’s safe to return to the euro? Safe haven buying of dollars and Treasuries falls and yields start to edge upward again. That’s not good for the housing recovery that the Fed would so like to engineer. And it could revive doubts about the efficacy of the Fed’s monetary policy moves at this point in the slow economic recovery.
How do I add up all this? The market is currently over bought. The U.S. market isn’t cheap on trailing fundamentals. The rallies in China, Brazil, and other developing markets depend on investors’ faith in central bank money flows. The risks don’t yet outweigh the potential rewards but we’re getting there.
The problem is that overbought markets can stay overbought for quite a while. And momentum of the kind that is carrying this rally can continue for quite a while. As much as I’d hate to get hit by a correction, I’d hate just as much to miss more of this rally.
When I last looked at an indicator called advisor sentiment from Investors Intelligence, the reading wasn’t yet in the danger zone. It has continued to climb since then with the percentage of bullish advisors climbing to 54.8% for the week that ended on February 15 from 52.1% for the week earlier. That’s getting close to the 57.3% peak in bullish sentiment in this indicator in April 2011 as stocks peaked. The percentage of bearish advisors fell to 25.8% from 28.7%. That puts the difference between bulls and bears at 29 percentage points, the widest spread in nine months.
So what am I doing?
I still think the big European Central Bank offer of three-year money to European banks keeps the risk/reward ratio on the side of reward through February 29. European banks are likely to draw down enough money from the central bank to fulfill their borrowing needs well into 2013 and that’s likely to be extremely reassuring to investors.
Add that to any positive effect from a Greek debt “solution” and I think we’ve got fuel for a continued rally into early March.
But in March I’d start to look to lower the risk in my portfolio. Gradually.
In U.S. markets I’d do that by raising some cash; substituting lower beta (less risky) stocks for higher beta (more risky) stocks; and looking to dividend stocks. (Beta is a measure of how risky a stock is in relation to the market as a whole. The market has a beta of 1. A stock with a beta or 2 is twice as volatile as the market as a whole.)
In China and Brazil and other emerging markets I’d gradually pare bets that are pegged to over-optimism about central bank policy and I’d look to emphasize domestic growth versus export growth.
I’d not recommending huge changes because I don’t think we’re looking at a horrible plunge in the market. I think we’re seeing a shift in risk/reward that might lead to a correction. (A reasonable estimate for a correction would be a pull back to 1250 or 1260—roughly 100 points from the February 17 close.)
But I’d like to shuffle my portfolio so that a market correction of 8% to 10% doesn’t produce a drop of 15% to 20% in the value of my portfolio because the stocks that I hold are substantially more volatile than the market itself. Those kind of stocks outperform in a rally but fall faster in a correction too.
I still think the second half of 2012 will be good to investors in stocks so I’m not recommending that you uproot your entire portfolio. In fact an 8% or so correction would be healthy for the market and would set up the second half of the year. But I would like to see you reduce the risk in your portfolio and raise some cash because I do think we’ll get a correction and a buying opportunity this spring.
If you aren’t comfortable with that kind of top-down call, do this instead. On a stock by stock basis in your portfolio look for instances where companies are reporting falling margins because of rising costs that they can’t pass onto customers. Look for growth cycles that may be reaching a peak. Make sure that the growth that you’re counting on to power a stock isn’t fading.
In the coming weeks I’ll try to give you some stocks that you can use to lower the risk in your portfolio and point out some stocks where the risk is rising and the reward is getting questionable.
As always, I suggest that you use this post as a challenge to your own thinking. I’d be quite happy if you wind up disagreeing with everything I’ve written here if the process has made you test your own assumptions about where we go from here.
And please remember that what I’ve given you is a relatively short-term take on the market. The big problems of rising U.S. debt, over-extended central bank balance sheets, and a falling dollar and rising U.S interest rates haven’t gone away. I just think that they’re problems for further down the road—like 2013.
Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund http://jubakfund.com/ , may or may not now own positions in any stock mentioned in this post. The fund did own shares of DuPont as of the end of December. For a full list of the stocks in the fund as of the end of December see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/