Divergences on the Horizon

To help visualize key aspects of the commentaries posted on this blog recently, the accompanying 2 charts illustrate important patterns that investors should keep a close watch on.

The first chart* covers the price action since the early March lows of this year for the three major US style categories – Mid (MDY), Small (IJR), and Micro (IWC) cap – and perhaps the single most important non US market, China (FXI). What is quite clear is that the higher risk categories have outperformed the lower risk, larger cap group S&P 500 – SPX) by a considerable margin. This is what is known in many circles as the beta trade: higher beta = better performance.

The second chart shows the beta trade continuing over the past three months, but not for all indices tracked. The beginnings of a meaningful divergence appears to be underway with China as price performance has begun to trail the four predominantly US indices.

Investment Strategy Implications

What you want to keep your eye on is any more substantial divergences between the big boys (SPX) and their lower quality/higher risk brethren and various global markets. As noted in last week’s commentaries, I expect such divergences to begin to emerge as earnings seasons unfolds and reveals an underwhelming performance by the higher risk US companies (represented by MDY, IJR, and IWC).

The wild card is the other index listed – China. I am in the camp that is more than a touch reluctant to drink the “China is great, no problem here” Kool-aid – a fact that the price action of the index may reveal in the coming months.

*click images to enlarge

The End User Dilemma

Back on August 3rd subscribers to my weekly newsletter - Sectors and Styles Strategy Report - read the following:

"China may become the bigger fly in the bullish ointment. Unlike the US, China has spent all of its stimulus package money not on consumer demand related areas (where it is most needed) but on more infrastructure projects. Since the US consumer is and will remain in balance sheet repair mode for a while and developed economy consumers (Europe and Japan) reluctant and/or unable to pick up the slack, end user (consumer) demand must materialize from emerging economies. With savings rates very high in China and other developing economies, expectations of V-shaped global economy recovery of a sustainable nature (meaning balanced and asset bubble free) seem fairly unlikely.

Therefore, a close eye should be kept on China and the very real prospect that a bubble burst may occur in that country. Should such an event occur, the global growth story becomes highly suspect, and equity values based on a global V-shaped recovery and expansion very problematic."

At the end of the day, somebody has got to buy something from someone else. The government may be the lender of last resort but it is not the buyer of last resort. That title belongs you and me - the consumer. And, despite its best Keynesian wishes, the prospect of demand being a guaranteed result of fiscal stimuli remains an unresolved mystery. Therefore, as helpful as next year's conveniently politically-timed US stimulus package will be, it cannot be, nor should be, counted on as lifting the world economy out of its end user dilemma. Moreover, government schemes like "cash for clunkers" get you only so far. They're like a life preserver keeping one's economic head just above the water, and nothing more.

Investment Strategy Implications

When stocks moved away from the abyss a certain sense of relief was taken to a modestly enthusiastic extreme. The more optimistic drank the valuation kool-aid of born again bullish investment strategists. "The more things change, the more they remain the same" became the mantra as business as usual replaced the panic-driven mindset - business most unusual.

With the past few days of market decline, perhaps reality will begin to sink into the valuation equation. Hopefully (but not likely), the vital focus on what is necessary for a sustainable global economic recovery will take center stage. And with it a concentrated effort to appreciate the end user dilemma.

2Q09 Earnings Season: So Far, So Good…

…but still too early to ring the bullish bell.

As earnings season begins in earnest and will soon kick into high gear, the fundamental valuation proof for equity prices’ faith (since early March) in an improved corporate profitability environment is the central issue at hand for investors. To justify current prices, second quarter earnings results MUST demonstrate that companies can turn in profits above consensus earnings expectations in an overall weak economic environment.

If 2Q09 results come in above consensus estimates (which are around $14 operating earnings for the S&P 500 - see table to your left), then stocks have a solid leg to stand on from which higher prices can follow as the second half of the year unfolds. Such a performance would signal that companies are able to produce sound earnings growth and profitability from the global economy while developed economies, such as the US, struggle with recessions followed by below potential growth.

Operating efficiencies, enhanced by recessionary-induced cost cutting, coupled with exposure to developing economies (which is where the global growth is and will be for the foreseeable future) are the ingredients for the potential of above consensus earnings results.

Conversely, should the numbers in the quarter just ended come in at or below consensus expectations, then concerns re valuation are justifiable. The valuation math in the near term is therefore not encouraging for the bullish case. To illustrate, take a moment to review the above table from this week’s “Sectors and Styles Strategy Report”.

The operating estimates for the S&P 500 for 2009 are in the mid $50 range. With the index at 900, that produces a 16.4 times P/E. Given the fact that the historical P/E for the S&P 500 in normal times is 15, it is hard to get overly enthusiastic for stocks with an above average P/E in less than normal times - which then brings into play the economic weeds that seem to be flourishing among the so-called green shoots.

Investment Strategy Implications

If companies cannot produce above consensus results (via global growth and operating efficiencies) and given the fragile state of the US economy, the suggestion is that the economic weeds that may strangle the US may also inhibit corporate growth and profitability such that earnings results will not justify even an average P/E.

The earnings results issued from several high profile names is, thus far, encouraging. However, as is the case with the technical analysis of stocks and the incomplete bottoming process, investors are well served to see how this plays out over the coming weeks as the earnings season provides more clarity on corporate profitability and the valuation justification for higher stock prices.

Welcome to the Emergent Emerging Markets Century

Okay, maybe it’s more than a tad premature to call a good couple of years the start of a century of exceptional economic performance. Nevertheless, if there is one place, from both an economic and investment basis, where investors are well advised to have an above average investment weighting it’s the emerging markets. The following presents a few core elements, both fundamental and technical analysis, which provide a hint as to why having such an exposure is prudent.

From a fundamental valuation perspective, EEM compares quite favorably to the developed economies on both a growth, diversification, and valuation level. As the first table shows, the mix of EEM (emerging markets ETF) is substantially different than that of either the S&P 500 and the EFA. What may be surprising are the large exposure to Info Tech and the relatively low exposure to Industrials. You can also see the favorable comparisons in P/E with beta where you would expect it to be.













From an economic growth perspective, the IMF chart that follows makes it abundantly clear that economic growth over the next few years resides in developing and not developed (advanced) economies.












From a technical analysis perspective, the above positives for emerging markets are reflected in the following charts.

The first chart shows the solid upside breakout from a significantly improving base that is poised to produce an mega trend reversal (regular readers of this blog know what that means), which has further upside potential for something beyond a tradable rally.












And from a comparative performance perspective, the non confirmation in early March has been rewarded with a far superior run thus far.












Investment Strategy Implications

The above provides a very brief description as to why emerging markets have exhibited and will likely continue to exhibit outperformance vis-à-vis developed markets. But don't take just me word for it - Mohammed El-Erian (Mister Bumpy Road to the New Normal himself) seems to think so. And he controls a lot more money (and influence) than little old me.

Krugman and El-Erian in the Valley of FUD

In his excellent book, “When Markets Collide”, PIMCO chief Mohammed El-Erian writes about the journey and the destination that the global economy and markets are undergoing and puts in context and helps clarifies much of the current economic and financial chaos. Mr. El-Erian describes a world that will be but is clear to note that the process of getting there may be “bumpy”.

Nobel laureate Paul Krugman points to the same concept in his blog posting yesterday (“After the Stimulus”) in which he lists the components of the US economy for 2007 and their averages from 1979 to 2007. As the accompanying table from his blog shows, the economic mix of the US economy got to be quite imbalanced primarily due to credit inspired high consumption levels by the US consumer. In the process, net exports became the counterbalancing force*.

As El-Erian declares in his book, a transformational world (economic and financial) is inevitable and has been underway for some time (long before the current credit and now economic crisis). And Krugman states, “Consumption probably isn’t going back to a 2007 share of GDP — savings are back. So what will fill the gap, once the stimulus is gone? Housing? Not for a long time. Business investment? Hard to see why. The natural thing would be to trade lower consumption for a smaller trade deficit.”

It is logical to assume that the US economy will experience two mega trends in the coming years:

• US consumer spending will fall while US consumer savings rise (aided by the baby boomers’ need to provide for their retirement years now that the wealth effect has gone kaput)
• Net exports will improve as global growth, particularly in emerging markets, continues to expand (certainly relative to developed economies)

It is also likely that non-residential investments (capex) will move closer to their average as corporations retool to meet the global export opportunities while government spending will increase as the US government seeks to stabilize the US economy (large fiscal deficits and other government programs like TARP).

Investment Strategy Implications

The bottom line for those investors willing to look beyond the valley of FUD (fear, uncertainty, and doubt) that we are currently wallowing in is to position their portfolios (what’s left of them) to exploit these mega trends. To follow this direction, however, requires context, perspective, and perseverance – something sorely lacking in a panic stricken financial climate.

*table contents
C = Consumer
N = Non residential investment (capex)
R = Residential investment (housing)
G = Government expenditures
NX = Net exports (exports minus imports)

Aftermath

In his award-wining book, “When Markets Collide”, incoming PIMCO CEO, Mohammed El-Erian makes the following statement: “…in contrast to past episodes of US economic slowdowns, emerging economies have two distinct secular forces going for them; and these should prove sufficient to partially offset what is likely to be a relatively prolonged period of lower import demand on the part of the Untied States. First, the internal components of aggregate demand are coming online in a gradual and robust manner, thereby offsetting the prospect of reduced exports to the Unties States. Second, these economies – and in particular the commodity exporters – are looking to a period of relatively high export unit values.”

Mr. El-Erian goes on to point out that “There is also a third factor that is more cyclical in nature. The robust nature of many of these countries’ balance sheets – historically unusual – gives them the ability to stimulate internal consumption and investment.”

Investment Strategy Implications

In the aftermath of the credit crisis, three patterns re the equity markets and economy appear to be underway:

• Sector rotation (within a bottoming process, range-bound market) producing the likely winners and losers of the emerging economic environment
• Secular trend of a slowing US (and other developed countries) growth (driven in large part by deleveraging)
• Secular trend of higher emerging economies' growth rates (an evolutionary form of decoupling)

Should the second two patterns become a reality, the first will likely show some manifestation of them, although the full effect of an emerging markets global growth driver may take some time to register with investors. What appears to be very intriguing is the prospect that US domestic growth-oriented investors will find themselves disadvantaged (from an investment performance perspective) if the global macro secular trends Mr. El-Erian and others describe do in fact occur. The logical result will be an investment situation similar to the end of the dot-com bubble phase when many value investors were forced into owning growth issues just to maintain some semblance of relative performance.

Clearly, the longer-term investment winners in the above described scenarios will be those who recognize the secular trends and act on them sooner rather than later.

Note: For those interested in learning more about one such emerging economy, Brazil, you might want to consider a program that I am affiliated with that will take place one week from today (October 28) at the Bloomberg headquarters in New York City. For more information and to register for Brazil Day 2008, click here

To register, use the following login and password:
login: vinny
password: vcatabd08

The Real Risks of Deleveraging

The deleveraging process that is dramatically impacting the economy and markets has two very serious consequences to it. One deals directly with the insane process of mark-to-market of illiquid, opaque assets. The other pertains to the effects deleveraging will have on the real economy. Allow me to highlight the key points of each.

In terms of the financial economy, the process of deleveraging can be characterized as feedback loops gone wild. Virtuous circles (and their accompanying animal spirits) give way to vicious cycles, in which lower prices beget write-downs, which beget lower prices. And on it goes. In the process, bad assets become toxic, especially for financial institutions who, unlike other entities, have capital requirements that must be met.

There is nothing new in all this. Bubbles and panics have been around for centuries. And bad behavior is always punished eventually. The larger macro economic issue is the fact that the global economy is in transition (listen to El-Erian’s comments below). The dominant question in such a macro economic environment is whether the transition will be an orderly or disorderly one (ex. a declining US dollar). What is new, however, is the impact that the rule change made last November that has turned a difficult situation into the disaster the financial markets are facing today.

Thanks to the well-intentioned actions of FASB last November and the updating of the accounting rule FAS 157, illiquid assets must now be marked to the current market price (mark-to-market) in an attempt to reflect the true value of the asset. This is all well and good were it not for the fact that marks in highly illiquid, opaque markets can produce a highly questionable reading as to what constitutes "fair value".

Moreover, when such marked-to-market assets are owned by financial institutions operating with high degrees of leverage often reliant on short-term financing with mandated capital requirements, you have a recipe for disaster. But don’t take my word for it. Listen to Paul Volker many months ago or Steve Forbes on Fox Business News last night*.

Lastly, so much of the current investment climate has been co-opted by short-term momentum players, many of which are aggressive short sellers. Does anyone seriously believe that these players are interested in what the "fair value" of an asset is?

All this creates a toxic climate for toxic assets.

The second risk re deleveraging is how it will impact the real economy. One effect is already being felt – fewer loans are being made. Gone are the days when credit cards, auto loans, and no-doc, no-income mortgages literally flew out the doors of financial institutions. Gone, also, are the very generous covenants attached to junk bonds. In their place is an austere environment where liquidity is abundant but the risk appetite in frozen with fear. This is all bad but what makes this situation highly dangerous is the state of the US consumer.

The US consumer, the spending workhorse of the world economy has a personal balance sheet that is in serious disrepair. In the current economic environment, the need to reduce debt and increase their personal equity will only come about through a process of savings out of income. Say goodbye to your personal (home) ATM. Say hello to a higher savings out-of-income rate.

But savings out of income coupled with extremely low levels of borrowing means that the US economy is on for a period of depressed economic activity. The shop-til-I-drop, I-must-sustain-my-unsustainable-lifestyle US consumer is toast. A weakened economic climate coupled with the negative wealth effect (from real and financial assets) and a looming retirement calendar will do that.

All is not lost. There are pockets of strength that can help alleviate the financial crisis and perhaps help avoid a worsening contagion to the real economy. For example, there is a segment of the world economy that appears to be poised to emerge as the source of demand – the emerging middle class of emerging economies. Growth in their economies should remain positive and, given their generally solid balance sheets (not to mention fairly good policy processes), should make a positive contribution to global growth and stability. Not quite 100% decoupling but more than the pessimists believe.

By the way, speaking of solid balance sheets, most investment grade corporations have very solid balance sheets. The ability to weather a financially-inspired storm is quite favorable.

Then there are the large pools of capital around the world that sit waiting for the crisis to resolve itself. From sovereign wealth funds to money market accounts to central banks, liquidity is more than ample.

Lastly, Americans have a great capacity to adapt, to innovate, and come together in common cause**. All these factors should not be ignored as they represent a path out of the credit crisis quicksand.

There is one final point that I wish to make.

Rule changes matter. FAS 157 is a well-intentioned rule that is rooted in an antiquated principle known as the Efficient Market Hypothesis. For while investors in the long run are rational and risk averse, in the short run they are anything but. Modifying FAS 157 would one very easy way to reduce the vicious cycle of mark-to-market.

Investment Strategy Implications

The technical damage done to the equity market is sufficiently bad (but interestingly not terrible) that aggressively adding to positions should be done with great care. However, a prudent portfolio management policy of sector tilting coupled with a mindful regard that stocks have an upward bias (see prior blog posting on this point) is always appropriate, made even more so when panicky selling rules the day.

*FYI - Little ole me has written on this topic on several occasions on this blog and in reports. I encourage you to use the topics link for credit related issues to your left to explore the writings further.

**This point is contingent on a less divisive political climate. Therefore: Memo to McCain’s advisors – cool it with the Karl Rove tactics. You may win the election just like W did, but you will cause severe damage to the country in the process, just like W did.)

W (not the movie)

The economic debate seems to have settled into which letter best fits the future trend of the US economy: V, U, L, or W?

The most bullish group, which includes many in the Goldilocks-redux camp, believe in the down (maybe strong) then up US economic scenario. V for victory, perhaps. Then there is the down then flat group, differing only in whether an upturn occurs sometime in the foreseeable future. U shows eventually, L says “who knows when?”. Some days things look up versus down and dirty for longer than you think.

The last group is the double dip club, my group. The US economy rebounds this year emboldening the Goldilocks dreamers to spout their dreams of an economic “morning in America”. Unfortunately for them, the false dawn will result in a “mourning in America” when 2009 rolls around and the tailwinds of the stimulus package give way to personal economic reality for many US consumers.

Driven by a negative wealth effect, US consumers spend less and save more for that retirement rainy day as concerns over Social Security and a diminished asset base begin to change habits. Such a change will take time, however, as the spending addiction of US consumers still has some strength to it – a strength that will likely exhaust itself thanks to the morphine known as the current stimulus package, fiscal and monetary.

Investment Strategy Implications

Oliver Stone may be working on a movie about George W. Bush titled “W”. But investors will likely spend more time next year focused on another W – the double dip in the US economy.

Short term, equities will likely continue to benefit from the dreams and hopes of the Goldilocks crew. And investors should continue to exploit that fantasy. However, a changed business model for most financial institutions will contribute to a diminished level of credit creation stimulus for the US economy, which when combined with a less profligate, more frugal US consumer will coincide with a new domestic political dynamic leaving only emerging markets to save the global economic day. And that may turn out to be more difficult than it appears.

The Economic Guessing Game Has Begun

In the past weeks, several clear signs have emerged signaling that investors are shifting their focus away from the credit crisis and toward the real economy and traditional investment analysis. The first and most obvious sign is the earnings reports. The next two are less obvious, but are no less important – the rise in the 10 year US Treasury rate and the increasing number of comments in the media and from economists re the direction of the US economy.

The 40 basis point rise in the 10 year US Treasury rate (from 3.31% on March 17 to 3.71% yesterday*) suggests a degree of relaxation in the flight to quality panic due to the credit crisis. This modest return to normalcy apparently implies that more than a few investors buy the credit crisis end is in sight story.

The other sign that investor focus has shifted is the increasing number of real economy related stories in the media. For example, the April 12th cover story in the Economist magazine, “The Great American Slowdown”, and yesterday’s FT commentary, “Road to ruin? America ponders the depth of its downturn”, explore the depth and duration of the US slowdown/recession. All this brings us to the emerging debate of the shape of US economy slowdown/recession – V, U, L, or W?

The more bullish sentiment is a V shaped decline and subsequent sharp economic recovery. Painful, yet short. The U shape crowd, on the other hand, believes the current difficulties will linger into next year when the end of 2009 comparisons show a sharp enough recovery and return to prosperity.

The L shaped advocates foresee an extended period of economic weakness a la Japan. Then there are the W shape believers, which is the camp I occupy. Things get better for a while (thanks to the stimulus package and the sustained strength of the global growth story – yes, Virginia, decoupling has worked to a meaningful degree) only to be followed by an economic decline into 2009 for a whole host of reasons, including a withdrawal from the US stimulus and a decline in US consumer spending and concurrent rise in US consumer savings (more on this in the near future).

Investment Strategy Implications

The US economy is undergoing a transformation on multiple levels that will produce major disruptions in the financial and valuation models for equities. These more thematic issues – credit crisis and its consequences, for example – will likely alter the economic landscape for years to come thereby producing substantial opportunities and risks. One outcome will almost certainly be a redistribution of economic growth in the US away from a US consumer dominated economy and toward a more export driven model.

That said, it is advisable to cover the traditional bases. Therefore, whatever shape your US economic doughnut might be (despite the fact that the credit crisis is likely to be far from over), the time has arrived for investors to form their view on the future direction of the US economy.

Beyond the Sound Bite: An Interview with David Wyss

Topics discussed include the prospects for a US recession, risks of contagion, decoupling, risks of large amounts of liquidity, the credit crisis, and a 2008 outlook for S&P 500 operating earnings and the 10 year US Treasury.

The length of the interview is 9 minutes 20 seconds.

The Eye of the Storm

excerpts form this week's report:

"Perhaps they haven’t felt it quite yet but the stock market bears should study yesterday’s Super Bowl for they risk looking a lot like Tom Brady – under siege.


As noted in Friday’s blog posting, the odds of a US (and potentially global) recession this year have diminished thanks to the stimuli from the US government and the Fed’s aggressive rate cuts. What this means is twofold:

• US equities should not be priced for recession, which means prices can...
• The economic effects from the stimuli appear to have a limited shelf life creating..."

Investment Strategy Implications

"The Model Growth Portfolio’s fully invested position reflects the view that equities are undervalued and higher prices should occur. While the global growth story may not produce a complete decoupling, last week’s economic reports..."

"As for the technical picture, it is debatable that we have entered a bear market. For example, much has been made by many market technicians that the Dow Theory has produced a sell signal. I beg to differ on this point, as the chart below (see report)..."

also in this week's report:

* Expected Return Valuation Model
* Moving Averages Scorecard
* Model Growth Portfolio
* Sectors and Styles Market Monitor
* Key US Economic Indicators

*To gain access to this week's report (and all reports), click on the subscription information link to your left.

Decoupling is Real

In the few moments we have before investors become consumed with news re Citigroup, inflation reports, etc., here’s a little data point that you might find interesting.

In a report published yesterday by Credit Suisse, evidence of decoupling can be seen in two charts.

The above first chart* shows quite clearly that the US economy means far less to China than it had in the past. As for the second chart*, Chinese domestic growth is not just strong but is actually accelerating.

Investment Strategy Implications

As the charts above show, there is ample evidence that decoupling is real. Therefore, while the US economy may suffer a recession, the global growth story appears to be intact. Maybe the end of the world is not just around the credit derivatives corner.

* click image to enlarge

2008 Themes: A Less Correlated World Part I – Decoupling

The political scene today is littered with the word Change, as Barack Obama captures the high ground on this issue. So, too, have the markets embraced the C word. Unfortunately, it is in the form of an economic change for the worse.

Yet, there may be another way to view the changing economic and investment environment, one that investors can more profitably exploit if my following thesis turns out to be correct. The change I am speaking of is a change in the degree to which economies and markets are correlated.

Over the past decade, markets, sectors, and even styles have become more highly correlated. I have noted this issue in previous blog postings. However, high correlations are not just the domain of the investment markets. As economies have become more interconnected they have, as a result, become more highly correlated.

All this may change this year.

Correlations may diminish this year driven by two forces – one economic, the other financial. In the case of our globally interconnected world, a change from high correlation may occur in the form of decoupling: most notably a lessened economic effect emanating from the US.

Granted, decoupling may not result in a significantly lower correlation as economies are influenced by each other to a large degree. However, decoupling may prove to be more prevalent than many think as policy actions undertaken by various other global actors, such as China, will likely produce stronger domestic demand thereby delivering the sorely needed non-US consumer demand to sustain global growth.

If so, then a US recession (or, more likely, a growth recession – growth below potential) will not have the same effect on global growth as it has had in the past. In my opinion, decoupling is not just possible but probable for two primary reasons.

To begin, the financial health of most economies is quite strong. For example, the current account balances of nearly every emerging market economy is positive. In the past, such economies have been a source of economic global turmoil. That is not the case today. Moreover, Eurozone economies are, for the most part, also in good economic shape.

As a result, containment of the pain in the US will likely be limited to domestically oriented businesses while the more globally oriented will reap the fruits of globalization and the global growth story. In this regard, what may be lost to some is the fact that businesses that serve a true global audience via the Internet may also experience positive economic results which will help minimize the damage of a credit derivative inspired economic contraction.

A second factor that will likely play out this year is the Olympic games to be held in China this summer. It is hard to imagine that the leaders and policy makers will not pull out all the financial stops to ensure a rosy picture.

As for the US, the damage emanating out of the credit derivative fiasco will almost certainly run its course over the first half of this year. Yet, given the political realities of a major election year, it is hard to see our government exercising an electoral death wish and not act to assist the US economy work its way out of what amounts to a financial, not economic, crisis. To the naysayers I say, the policy tool kit contains many more instruments than you are giving it credit for.

Investment Strategy Implications

There is a considerable amount of skepticism regarding decoupling. And that skepticism is deserved. After all, the world has function a certain manner for just over a century. Yet, as is the case with the US political scene, meaningful change may be occurring below the radar of many investors. Globalization, the Internet, and financial innovation are just a few examples of a changing world.

Many are uncomfortable with change. For change means a disruption of the status quo. Ways of life are constructed around the status quo, as processes and systems enable the early adopters to gain competitive advantage and the spoils thereof.

Yet, change, for good or ill, is the one constant in life. Recognizing it can produce alpha.

Note: Tomorrow, in Part II, I will explore the issue of lower correlations between and among markets and sectors.

Feed Me!

Gone largely unnoticed, the Global Consumer Staples ETF (KXI) has been producing a very nice return to investors. Benefiting from the global growth story, KXI’s holdings are well positioned to provide the basics of modern life as the populations of the emerging economies gradually migrate to the middle-income strata of their respective societies.

Since its introduction one year ago, KXI has outperformed the S&P 500 and the more domestically oriented Consumer Staples XLP (see chart above*). The standout reason for the outperformance vis-à-vis XLP is illustrated in the composition of their top ten holdings. As the table above* shows, XLP is much more heavily concentrated both in the top 10 holdings as a percent of the total portfolio as well as its two largest positions, PG and MO.

Investment Strategy Implications

KXI provides investors with a vehicle to play the rising middle-income classes of emerging countries. While the US economy may slump, the global growth story remains intact (unless, of course, you don’t buy the decoupling scenario). Additionally, anyone seeking to stay in the aged bull with a reduced level of risk, consumer staples as a group is a place to be. (It should be noted that the weak US dollar has aided the US oriented XLP as more issues in that portfolio are major global providers benefiting from the falling dollar, as evidenced by the fact of its near equal performance over the past several months.)

With a P/E just a notch above XLP and a beta of .68, KXI should be on every moderate to conservative investor’s radar screen.

*click on images to enlarge
Note: The above is strictly for informational purposes and should not be construed as a recommendation to buy or sell any securities. Please consult your financial advisor. Neither Vinny Catalano nor any member of his family owns the above referenced securities. Accounts managed by Blue Marble Research do have positions in the above referenced securities.

Hurry Up, Hank!

The search for the magic formula (see last Thursday’s blog posting) is running into serious roadblocks and the financial powers that be must resolve the re-engaged credit freeze asap. With each passing day, the failure to create the new financial order puts increasing strain on the core of the system – something that cannot be allowed to metastasize into the real economy. Dangerously, such a risk seems to be on the rise. Yet, at the same time, the excess liquidity sitting in the coffers of institutional investors (including hedgies) along with reasonable earnings growth suggests that the downside risk to equities is limited.


The two above dichotomous points are captured quite clearly in the following three excerpts from the must read FT Alphaville:

“The perceived riskiness of European corporate debt increased on Tuesday as traders in credit default swaps, worried the credit squeeze will ripple from banks to the wider economy, drove spreads wider. Concerns for banks’ balance-sheets were exacerbated yesterday when the one-month sterling Libor rate hit a nine-year high. There were growing signs that tightening credit was hitting consumer demand as restaurants, credit card businesses and property funds began to feel the strain.”

“Five hedge fund managers at London’s Marble Bar Asset Management will share at least $400m after agreeing to sell their five-year-old firm to EFG International, the Swiss bank.”

“Warren Buffett has rediscovered his appetite for junk bonds, buying $2.1bn in debt issued by the Texas utility TXU in a move that suggests value-seeking investors are prepared to step back into the troubled credit markets.”

So, there you have it in a nutshell. The core of the system has reentered the deep freeze with the increasing risk of spillover to the real economy while investment capital remains abundant, and abundantly rewarded.

Investment Strategy Implications

One week from today, the Fed’s interest rate decision will be a no brainer – another ¼ point cut. That will put the Fed 2/3s of the way toward the normal rate cut response (1 ½%) to a potential domestic economic slowdown. However, rate cuts alone will not do the trick. The magic formula must be found - and quickly - as there is little about the current situation that is normal.

As for equities, signs of a topping process increase. As noted in yesterday's weekly report (subscription required), the infantry is abandoning the effort as Small and Micro cap have significantly underperformed of late leaving only Mid cap standing. It is, however, far from being a done deal. Counterbalancing positive factors (valuation, global growth story, investment liquidity) provide support for higher equity prices, or at least limiting the downside risk. Yet, these positives can evaporate in short order if the magic formula cannot be found.

Time is not on anyone’s side.

The Enduring Bull Market

excerpts from this week's report:

“Quite a few people have been asking lately why on earth the equity market is so high, but I make no apology for joining them. If the Dow can rise 540 points in two days - as it did last week - something rather odd is going on.”

So writes Tony Jackson in today’s FT commentary, “Glum conclusion is equity investors are still in denial”. And herein lies the problem with viewing the equity markets solely through the prism of the real economy.

For while nearly all the references in Mr. Jackson’s commentary today cannot be disputed, one can be correct in factors pertaining to the real economy yet wrong when factors pertaining to the financial economy (the markets) are at odds with or offsetting the real economy issues noted.

Yes, there are ample reasons to be concerned re the credit crunch. Yes, there are many causes for concern re the credit crunch and its potential effect on emerging markets and the damage that can be done to the decoupling argument. And, yes, the markets may be foolish to be “starting to price in a return to more normal profitability after a long and exceptional bonanza.”

All true, all logical, and all flawed if one chooses to ignore the counterbalancing factors of valuation, equity market liquidity (as in the hands of hedge funds and private equity players), and the conditions favorable for decoupling.

Moreover, while fundamentally oriented investors may choose to, I believe that ignoring the technical analysis factors is done at one’s own financial peril.

Here are a few comments on each of the positive points noted..."

also in this week's report:

* Expected Return Valuation Model
* Model Growth Portfolio
* Investor Sentiment Data
* Chart Focus: ISM Indices
* Sectors and Styles Market Monitor
* Key US Economic Indicators

To gain access to this and all reports, click on the subscription info link to your left.

The Year End Rally in Waiting

Now that we are well into the current earnings season several earnings trends are matching recent stock performance, most notably the polar ends of the performance scale - Financials and Tech. As the table* to your left shows, however, the overall earnings picture ex Financials is about in line with expectations - low single digit growth.


Investment Strategy Implications

Once tomorrow's Fed rate decision is behind us, the year end price action for equities will depend in part on the answers to three key questions:

• Will the US economy experience a soft or hard landing?
• Has the global economy decoupled from the US to a sufficient degree that will enable global growth to remain robust?
• How far along are we in the black hole of credit derivatives discovery process?

Notwithstanding all the issues that threaten to derail the aging bull, with liquidity so abundant, corporate and nation state finances in excellent shape, valuation levels reasonable, and technicals in compliance, should all three questions be answered in the affirmative the odds for a decent if not strong end of year rally are high.

*Click image to enlarge.
Source: Wall Street Journal

"The Fever Will Break. It Always Has."

excerpts from this week's report:"

"So said the Maestro during yesterday’s 60 Minutes interview referring to the current credit squeeze. And despite the run-on-the-bank visuals of British depositors of Northern Rock standing on line, passbooks in hand, the growing impression from this desk can be summed up in two words – Old News. In fact, we seem to getting to the point where it's time to say, in the words of the Chris Matthews show, “tell me something I don’t know.”

"Without a doubt, other shoes will drop. But it’s going to take a very big shoe (global growth slowdown, for example) to impact the overall market. Anything less will simply damage the affected area in question and not likely bleed into sectors of the global economy. "

"The large economic issue is Decoupling. That is now the key area to focus on. It is about to get its long awaited test. All indications point to a US economic slowdown, or worse. The US consumer will likely cut back spending. But the investment strategy question to answer is “Just how much does that matter?"..."

"Model Growth Portfolio re-balancing:
Reductions
-2% Consumers Staples
-2% Oil Equipment and Service
-1% Gold

Additions
+2% Homebuilders
+1% each Telecom and Utilities
+1% Europe 350"

also in this week's report
• Valuation Model
• ETF Model Growth Portfolio
• Model Growth Portfolio re-balancing
• Key Economic Indicators

Note: To gain access to this week's report (and all previous reports), please click on the Blue Marble Research Subscription link to your left.

If Not Now, When?

While investors sit around staring at their screens waiting for next Tuesday, perhaps a few words re the arguments pro and con a rate cut would be a worthwhile exercise.



The argument for a rate cut is predicated on the assumption that the US consumer, under increasing economic stress, will cut back on his/her shop-‘til-I-drop mentality thereby impacting global growth, potentially bringing the world economy to its knees.

A supporting element of the rate cut argument is the disbelief that decoupling (global growth continues without the major support from the US consumer) will fill the gap and sustain global growth and corporate profits and profitability.

A final point supporting a rate cut is the holdover belief that a preemptive approach to matters economic should be maintained. This was a staple of the Greenspan era and one that many still advocate.

The counter arguments made against a rate cut center on the beliefs that (a) decoupling, even in a less than completely robust form, will be more than sufficient to sustain global growth (even if individual regions and/or countries suffer to some degree), (b) a long, overdue adjustment of financial innovation-juiced growth is necessary, and (c) issues like structural imbalances (global demand, current account deficits, trade deficits) must be corrected.

Supporting the no rate cut argument is the fact that the combination of corporate and emerging countries’ financial condition has never been better thereby enabling any pain to be experienced will be manageable.

In my humble opinion, the latter should be allowed to play out further. In other words, a rate cut blast to the entire system (the point of yesterday’s little soap opera dialogue) is neither warranted nor appropriate at this time. The targeted, surgical approach currently employed by the Fed should continue and the blockages in the financial system should be addressed directly versus a blast the system Fed rate cut.

Now, for those that say that unless the Fed acts now with a rate cut a recession is inevitable, I offer this: If you could not foresee the credit fiasco we are now experiencing why should we believe you now?

What if you are wrong and a recession is not just around the corner? What if global growth remains reasonably robust? What if the US economy was poised to simply experience a slowdown and not a recession? If so, what is the likely consequence of an economy-wide rate cut? Perhaps an overheated global economy?

If bad behavior (which includes financial innovation-juiced deals and the structural imbalances points noted above) and questionable decision-making needs to be changed, what better time to make that change than the present – when the global economic wherewithal exists? If not now, when?

The Dark Side of Globalization: The Next Big Shoe to Drop?

While investors rightly fret over the unfolding risks of the credit squeeze, perhaps it’s time to consider the real economy side of the equation – the dark side of globalization.



Just as liquidity and financial innovation has worked their mutually reinforcing wonders for oh so many years, so too has globalization enjoyed the free ride of risk-less thinking. The benefits produced by globalization are as abundant as the free flow of capital. Platform companies deliver low cost goods to developed country consumers. Developing countries experience growth rates in the double-digit range and, in the process both raised the standard of living for their citizens as well as helped fill their governmental coffers as never before. In fact, assets have accrued so significantly to many developing countries that current account surpluses abound giving rise in some cases to sovereign wealth funds.

These examples are just a few of many that could be cited. And the good that they produced in reducing global poverty while enriching both corporate and governmental entities cannot be overstated.

There is another benefit to globalization that is particularly relevant to the current credit squeeze – the ability of emerging countries to (a) withstand any global growth slowdown emanating out of the US and (b) to act as a source of demand helping to limit the damage of a US consumer-led global slowdown. It is this second point, also known as decoupling, which when combined with inherent quality of globalization - interconnectivity - that is the potential dark side of globalization.

Decoupling, which heretofore has not been put to the test, assumes that markets and economies outside the US have grown sufficiently robust that even a recession in the US will not push the global economy into a recession. Given the interconnected nature of the world economy and markets, however, it cannot be assumed that there will not be a ripple effect (a contagion) from a slowing demand from the engine of global growth, the US consumer. Nor can it be assumed that the still immature developing countries’ economies and markets are sufficiently developed that they are capable of picking up the slack.

Investment Strategy Implications

The big risk in the current credit crisis is the vast unknown. What investors don’t know is wreaking havoc with confidence, a key element of asset management, credit decisions, and general investing. Until there is clarity as to what exactly we are dealing with, discretion should be taken when making investment decisions.

The big risk with globalization centers on the interconnected nature of world markets and economies. Decoupling has been bandied about as the savior of a US consumer-led slowdown/recession. But, as with the knowledge black hole of credit derivatives, no one knows if decoupling will work. Nor does anyone know just how a highly interconnected world will function in an economic and/or financial crisis.

These are the primary risks that were dismissed for far too long by far too many Goldilocks-entranced Pollyannas. These are the risks that must not be allowed to get out of control.