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Reasons for Optimism: Equity Thoughts and Forecasts for Q4 2010

“…the big money was not in the individual fluctuations but in the main movements, in sizing up the entire market and its trend…nobody can catch all the fluctuations. In a bull market your game is to buy and hold until you believe that the bull market is near its end.” 1 Jesse Livermore

These observations were made nearly a century ago, yet they are as relevant today as they were then. In adopting Mr. Livermore‟s approach and sizing up the entire market and its trend,‟ I still believe we are in a bull market. As such, our game should be to „buy and hold until (we) believe that the bull market is near its end.Furthermore, we must accept that we cannot „catch all the fluctuations‟ the most recent of these being the ~17% stock market dip over the summer months. That corrective phase has at least paused and is, in my view, entirely behind us. As JP Morgan‟s Jan Loeys put it, the subsequent global rally in September was not built on signs „that the world economy improved. It did not.

The good news was simply that the economy stopped getting worse.‟ 2

Core Reasons to be Bullish Loose Monetary Policy Attractive Valuations De-Equitization Pessimistic Sentiment
Core Reasons to be
Bullish
Loose Monetary Policy
Attractive Valuations
De-Equitization
Pessimistic Sentiment

It is true that over the last several months the

supporting arguments have shifted, while the general conclusion of being positive on equities has remained unaffected (thereby risking the label of perma-bull). Regardless, this stance is currently built on four core conditions:

1)

Loose monetary policy

2) Attractive valuations 3) De-equitization 4) Pessimistic sentiment and positioning

This piece discusses, in turn, each of the supporting arguments to the bullish thesis and

closes with a synopsis of the risks. Lastly, in an attempt to clarify exactly what an outlook means for asset allocation purposes, I introduce

a Model Portfolio Allocation. The current

positive outlook on stocks is expressed in a tactical overweight of equities versus bonds.

Model Portfolio Allocation

 

Neutral

Recommended

Allocation

Tactical Target

Fixed

   

Income

35%

25%

Equities

65%

75%

1 Reminiscences of a Stock Operator, Edwin Lefevre a thinly veiled biography of Wall Street legend Jesse Livermore 2 JPM Global Markets Outlook and Strategy, October 6, 2010

Loose Monetary Policy

The pressure on central banks to tighten earlier in the year has been replaced by exactly the opposite: pressure to ease further. This shift in sentiment from a tightening bias toward loosening was driven by poor economic data over the summer months. Beginning with Bernanke‟s speech in Jackson Hole on August 27 and continuing through September, the Fed made it rather clear they are willing to step in and reflate the economy in order to avoid a double dip. One interpretation of Fed Policy comes from Bloomberg‟s Rich Yamarone:

During the Sept. 21 meeting of the FOMC, the Fed said, "Measures of underlying inflation are currently at levels somewhat below those the Committee judges most consistent, over the longer run, with its mandate to promote maximum employment and price stability." This is Fed speak for "We are closer to deflation than any other time in post World War II history, and we aren't going to let it happen under our watch."

Since it is impossible to go below zero percent on short term rates, the Fed „eases‟ by adding more Quantitative Easing (QE) or as they now call it, Large Scale Asset Purchases (LSAPs). This diagram from Bloomberg, which displays the three ways the Fed is encouraging risk taking behavior of market participants, appears more relevant than ever. In other words, they are pushing

investors (kicking and screaming) to move further out on the risk spectrum…out of treasuries and into high yield credit or equities. Irrespective of whether their efforts will be successful, a first

order effect of this commitment toward reflation is a risk asset rally. Thus, (ultra) loose monetary policy remains the number one reason to be bullish on stocks.

policy remains the number one reason to be bullish on stocks. October 11, 2010 Page 2

Attractive Valuations

There are several ways to approach valuation, most of which are pointing to a stock

market that is trading at attractive absolute and relative valuations. As discussed in the Q2 outlook and shown in this equation to the right, the

current market price is made up of two components: 1) the PV of trailing 12 month EPS into perpetuity and 2) the PV of earnings growth.

PV of Current Earnings
PV of
Current
Earnings
PV of Current Growth in Price of Earnings S&P 500
PV of
Current
Growth in
Price of
Earnings
S&P 500
PV of Current Growth in Price of Earnings S&P 500 Currently, the market is pricing in

Currently, the market is pricing in negative earnings growth for the S&P 500 because the present value of current earnings is 15% greater than the current value of the S&P 500! See the chart to the left from Citi.

Looking at equities relative to bonds, the S&P 500 earnings yield is currently 6.6% while ten year BB yields are trading at 6.76%. (BB is the second highest notch of „non- investment grade‟ bonds) This is rather unusual and speaks to the „cheap‟ relative value of stocks versus bonds.

Concurring

with

this

assessment

are

from

Warren

Buffet on CNBC, “It‟s quite clear stocks are cheaper than bonds. I can't imagine

anybody having bonds in their portfolio when they can own equities, a diversified group of equities.

BB Yield minus S&P Earnings Yield

4.000% 3.500% 3.000% 2.500% 2.000% 1.500% 1.000% 0.500% 0.000% 2003 2004 2005 2006 2007 2008
4.000%
3.500%
3.000%
2.500%
2.000%
1.500%
1.000%
0.500%
0.000%
2003
2004
2005
2006
2007
2008
2009
2010

De-Equitization

In stark contrast to the aggregate over-leveraged balance sheet of the American consumer, corporate America sits on a conservative, cash rich balance sheet. What‟s a corporation to do? There are really only a few options for a corporation with excess cash on the balance sheet: do nothing, invest (capital expenditures or hiring), acquire, or return to shareholders (dividends or buybacks). Corporations are doing and will continue to do all of these things with their cash. The option that is increasingly attractive and probably has the largest impact on equities is share repurchases.

De-equitization isn‟t just about companies using excess cash to buy back shares, it also occurs when companies issue debt for share repurchases. Contrasting corporate America once again with the American consumer, we see that corporations, on the whole, have access to plentiful and cheap credit. In many cases, it is profitable for a company to access the credit markets to sell expensive debt and use the proceeds to buy back less expensive equity. In doing this they are realigning their capital structure, lowering their Weighted Average Cost of Capital (WACC), and instantly boosting ROE (by decreasing the denominator more than the numerator in the equation: Net Income / Equity).

De-equitization is the general idea of corporate balance sheets being a large incremental buyer of equities. Given the benefits of the strategy and the current position of corporate balance sheets, it seems likely that this trend will resume after pausing 2009. Such a development would provide additional support to stock prices.

a development would provide additional support to stock prices. October 11, 2010 Page 4 of 8

Pessimistic Sentiment & Positioning

July and August saw sentiment indicators hit deeply pessimistic levels. One might expect September‟s 8.76% rally to instill confidence, but focusing on measures that indicate what investors are doing, rather than what they may be saying in polls, it appears they continue to view equities with healthy skepticism. When there is persistent doubt in the face of a rising market that is often contrarily positive for equities.

As

investors in equity mutual

rule,

a

general

funds

have

the

art

of

timing down

to

a

fine

and

sell low. To the right is a

science…Buy high

chart

of

mutual

fund

flows

from

which

indicates that investors are selling their „risky‟ equities and buying „safe‟ bond funds.

Equity Mutual Fund Flows Bond Mutual Fund Flows $50,000 Net Buying $40,000 $30,000 $20,000 $10,000
Equity Mutual Fund Flows
Bond Mutual Fund Flows
$50,000
Net Buying
$40,000
$30,000
$20,000
$10,000
$0
($10,000)
($20,000)
Net Selling
($30,000)
Jan
Feb
Mar
Apr
May
Jun
Jul
Aug
Sep
Oct
Source:

Short Interest data from Bloomberg shows that investors have continued to short stocks, even as prices climbed in September. This indicates that investors continue to be skeptical on the durability of the rally and they are positioning accordingly.

the durability of the rally and they are positioning accordingly. October 11, 2010 Page 5 of

The last sentiment measure is the Panic/Euphoria Model from Citi‟s strategist, Tobias Levkovich. He does not divulge the exact inputs but taking it from his description as being a measure of how „investors are positioning themselves‟ (as opposed to what they are saying), it is particularly interesting that this remains in panic territory.

interesting that this remains in panic territory. The fact that these measures indicate that investors are

The fact that these measures indicate that investors are bearishly positioned contrasts with several sentiment polls that show investors are optimistic. It is indicative of an environment where market participants are saying one thing but they are not backing up their words with actions. At such times, it seems rational to put heavier weight on indications of how investors are actually behaving. In other words, talk is cheap.

Anecdotal conversations concur with this lack of belief in a stock market rally. Ask a bearish tilted investor at what point they throw in the towel and cover or move to a neutral allocation: when we hit new highs? When we get to 1,300? My experience has been that they don‟t have an answer, which is probably indicative of a high level of confidence in their negative tilt. Perhaps they will be correct, but the fact remains that investors on the whole are rather vulnerable to a rally in stocks and that creates the potential for higher prices leading to still higher prices. George Soros would call this reflexivity, while others might describe it as a momentum driven market. Regardless, markets have a tendency to sniff out vulnerability and punish it. All of this adds up to a market condition of there being more incremental buyers than sellers and that is, on balance, bullish.

Risks

Federal Deficit One of the largest risks right now is the size and direction of the federal deficit. It is like

a giant super tanker heading toward a rocky shore. Some solace comes from the fact that we have been at worse levels before, albeit, never in peace time.

been at worse levels before, albeit, never in peace time. Getting this under control or at

Getting

this

under

control

or

at

least

developing

some

ideas

for how to start heading

in

the

right

direction

would

reduce

some

anxiety

around

this

looming risk.

 

The bi-

partisan

on

 

and

was

charged

with advising on this topic. The good news is that both democrats and republicans are still at the table. The real test comes on December 1, 2010 when the commission must issue its full report.

If a convincing solution is not proposed or if its implementation

seems implausible, most investors judge that would negatively impact equities in 2Q

or 3Q of next year.

(Source: CIRA US

Equity Strategy)

in 2Q or 3Q of next year. (Source: CIRA – US Equity Strategy) October 11, 2010

Long term inflation An increase in the Fed‟s balance sheet from higher QE/LSAPs, ultimately increases the risk of an inflation blowout in several years. Also, it raises the perception that the Fed is monetizing the debt, which decreases demand for treasuries.

Other Risks This is how a survey of Institutional Investors from Citi ranks the current risk landscape.

Investors from Citi ranks the current risk landscape. This is how institutional investors view „tail risks‟

This is how institutional investors view „tail risks‟ from BofAML‟s Fund Manager Survey:

view „tail risks‟ from BofAML ‟s Fund Manager Survey: October 11, 2010 Page 8 of 8