Turning Cautious as Markets Embrace QE2

Includes: NIHD, SPY
by: Jeffrey Saut

Excerpt from Raymond James strategist Jeffrey Saut's latest essay (published Monday, October 18th):

...Compressing three trillion dollars of spending into a one year timeframe works out to roughly $8.2 billion per day – or $341 million per hour, or $570,000 per minute, or $9,600 per second – plainly, “Gone in 60 Seconds.”

Nevertheless, the various equity markets seem to like the thought of QE2 as they have soared since Ben Bernanke first telegraphed it in his Jackson Hole speech. As the must have GaveKal organization opines, “The jump in risk assets would imply the market is expecting stronger growth as an eventual result of a new round of Fed asset purchases; but at the same time, the fixed income markets seem to be voting entirely the other way.”

Recently, however, the bond market also seems to be pricing “in” a stronger economy. To be sure, the yield on the 30-year T-bond has risen from its August “low” of ~3.4% to its current yield of ~3.99%, which has eclipsed its “yield yelp” of 3.96% recorded in mid-September. Rising interest rates are certainly a risk to my bullish equity bias, yet I continue to think it won’t be all that impactful to stocks in the short run. Importantly, I believe improving profits, upside momentum, and game theory (performance risk, bonus risk, and ultimately job risk) reign supreme for underinvested, equity-centric, portfolio managers (PMs), which should force them to buy stocks into month’s end.

Recall that many mutual funds close their “books” in October, putting even more performance pressure squarely in the “cross hairs” of portfolio managers. Moreover, the potential sentiment-changing midterm elections are also acting as a “carrot in front of the horse.” Consequently, to an underinvested PM, the past few months’ upswing in stocks has been a nightmare. That said, the equity markets are currently overbought and my sense is we could see a short-term “peak” in stock prices between now and post the November elections. Still, I think any pullback will be mild followed by higher equity prices. So again I say, “I think it is a mistake to get too bearish despite ‘death crosses,’ Hindenburg Omens, Roubini revelations, and Prechter plunges.”

As for QE2, there are two approaches the Fed can take. It can sterilize the move by absorbing the new reserves with other instruments, or it can leave the new reserves unsterilized. Each approach has its concerns. Again, as my friends at GaveKal note (paraphrased by me):

1) If the Fed decides to make unsterilized purchases of long-dated US Treasury securities, the result would be to throw short rates into negative territory. This does not seem to be what the market is discounting. The short end of the yield curve is inverted, but not enough to signal expectations for negative short rates... With the effective Fed funds rate at around 21 bps, this again suggests that the market is not discounting negative short rates, i.e., unsterilized purchases of long US Treasury bonds. On the other hand, TIPs breakeven inflation rates rose by some +25 bps last week, a result we would think consistent with expectations for unsterilized purchases.

2) If the Fed purchases long bonds and then at the same time absorbs the new reserves by issuing short dated liabilities (sterilized purchases), short rates will stay above zero. The outcome would be a flattening of the yield curve. . . . Rarely is a flattening of the yield curve received by the market as cause to increase its expectations for growth.

To me, the various markets are “saying” we are in a low growth environment with inflation due to eventually arrive. I also think the current expansion is self-sustaining -- and additional QE will ensure that outcome. While economic growth will be slow, I remain confident the expansion is durable and is going to-- at times-- surprise on the upside, like last week’s Empire Manufacturing and Retail Sales reports. If correct, it is far too soon to worry about equity valuations, a fact third quarter earnings’ reports are again reinforcing.

So where does this leave the stock market? As stated, the stock market is pretty overbought with 77.6% of the S&P 500’s stocks more than one standard deviation above their respective 50-day moving averages (DMAs). The McClellan Oscillator is also overbought. Then there is my day count sequence, which shows the S&P 500 (SPX/1176.19) standing at session 32 in the current up move without anything more than the perfunctory 1 – 3 session pause and / or correction. Typically such buying stampedes exhaust themselves in 17 – 25 sessions. A few have lasted 25 to 30, but it is rare to see one extend for more than 30 sessions. Therefore, I am turning cautious, but not bearish, believing any correction will be mild and followed by higher prices. Yet, one of my stocks has already “bear market” corrected as NII Holdings (NIHD/$38.03/Strong Buy) fell ~19% late last week when a Mexican newspaper reported that Televisa (TV/$21.98) was considering backing out of its agreement to buy a 30% stake in Nextel Mexico for $1.44 billion.

According to our telecom analyst, while no definitive announcement has been made, there is still a high likelihood that --at a minimum-- Televisa continues to work towards commercial agreements with NII, which will allow Televisa to provide wholesale wireless service to its cable TV and satellite TV subscribers. If Televisa does back out of the deal, NII still has the balance sheet capacity to build out a 3G GSM network in Mexico, which is estimated to cost $1 billion in capex/opex, spread over multiple years. NII ended 2Q10 with approximately $2.4 billion in cash and gross debt of $3.5 billion (net leverage of 0.8x on 2010E C-EBITDA). Our earnings model assumes the construction of 3G networks in Mexico, Chile, and Brazil, as well as the purchase of 3G spectrum in Brazil for $600 million. And this morning, Televisa has indeed canceled the contract with NII causing one savvy seer to scream, “Buy on the cannons!”

The call for this week: The likelihood of the QE2 has risen dramatically since Ben Bernanke’s Jackson Hole speech. This is being reflected by the “stubborn rally” in most asset classes. If Bernanke did not think QE2 was needed, he surely would not allow such speculation because he does not want to surprise the various markets. Nevertheless, I am again cautious, a state I have not been in since April. Still, I think any ensuing pullback will be mild and contained above the 1130 – 1150 level on the S&P 500.

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