Wednesday, September 23, 2009

V Shaped Rally ≠ V Shaped Recovery

Yesterday’s posted interview with David Malpass brings into sharp focus a key aspect of the US economic recovery that far too few investors are tuned into. Specifically, the underappreciated dynamic that second, third, and lower tier companies (the backbone of employment growth in the US) may not deliver the much anticipated above consensus earnings results this and future quarters ahead. Moreover, as the backbone of employment growth, weakness in second, third, and lower tier companies act as a depressant on wages, hours worked, and consumer sentiment. Therefore, how the US (and global economy) will reach a sustainable recovery without the US consumer is a riddle wrapped in an enigma.

Lacking a large exposure to global markets (where the growth is and where the weak US dollar helps deliver strong short term results), the SMIDS (small and mid cap companies) on down are vulnerable to disappointing investors with at or below consensus earnings results next month. In this regard, David points out in the interview that above consensus earnings results this coming 3Q09 for large and mega cap multi nationals may come to pass via pricing power pressures on all companies offset by volume growth courtesy a cannibalization of the units growth to lower tier companies.

(As a reminder, 2Q09 bottom line results surprised to the upside thanks to cost cutting, as top line growth was largely in line with expectations. In the current quarter ending next week, expectations are for above consensus earnings results produced by top line growth that surprises to the upside (with cost cutting is largely done). With the US economy still on its knees, it is hard to see how US domestic top line growth (revenues = price x units sold) can surprise to the upside. How this happens for companies that will not benefit from global markets (and a weak dollar) is a mystery soon to be revealed.)

Investment Strategy Implications

In a liquidity driven stock market, all logic goes out the window – for a while. Justifications for over valued markets abound. And buy high to sell higher becomes the music that all performance based investors must dance to. Phrases like “melt up”, thanks to expectations that the $3.5 trillion sitting in near zero percent money market funds will be forced into equities, is the support rendered for P/E ratios that warrant above average (i.e. 15 times) levels. Sound familiar?

In such times, a prudent investor is a contrarian investor. Momentum driven/fast money “investors” awaiting sideline money to sell to on the basis of melt ups and a sustainable global economic recovery rooted in a deleveraging US consumer may turn out to be a fantasy bubble about to burst.

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