Satya Pradhuman founded Cirrus Research in 2007 after more than 20 years on Wall Street as a respected and often-quoted executive in the equity research departments of E.F. Hutton, Lehman Brothers, and Merrill Lynch.
Harlan Levy: How fragile is the U.S. economy?
S.P.: To date, in the U.S equity market, the U.S. economic backdrop is mixed. We have marginal signs where credit expansion and employment levels are stabilizing. Loan growth activity collapsed several years ago, and three or four years later appears to be stabilizing. It was down 12 or 14 percent. Today, three and a half years later, it’s come back to being flat. At the same time we’re looking at levels of bank liquidity that are continuing to become more difficult.
The challenge that we face today is two possible outcomes that could be radically different: On the one hand, the European sovereign credit issues spiral out of control and cause a freezing of the banking credit system. On the other hand we could see a reenactment of the version of the bank bailout. We are on a precipice and depending on whom you speak to, the outcomes could be more in one camp versus the other.
Our belief is that the market has been very aggressive and has priced in a very dark outcome.
H.L.: Do you think the European Union and the eurozone will survive, and what do you see in the end?
S.P.: We think there should be some stabilization in the European debt crisis to some degree. Equities have fallen so sharply that it’s more than reasonable that we could see some lift in equities as the market breathes with relief with banking liquidity measures stabilizing.
What’s different in this period from 2008 is that going into the fall of 2008 banking liquidity had seized up for almost 18 months. When you look at 2011, we’ve actually seen the market fall down 15 to 20 percent, depending on the time frame we look at, without the banking system freezing. Banking liquidity measures have been steadily deteriorating, but they are still within some reasonable band.
But because it’s multi-government, it’s very difficult to construct how the system fundamentally stabilizes. Some bank support for the European system could stabilize banks on the whole. That said, the debt situation is severe enough where these agreements could be revisited, and you could end up seeing some sort of a rolling brown-out with banking liquidity measures being tested again and again.
H.L.: Is the U.S. in a recession?
S.P.: No. The U.S. is not in a recession. We’ve got very sluggish growth and a recovering economy that’s been tested severely in 2011. Two random events could be masked as a recessionary environment. The tsunami in Japan created severe supply chain shocks in the U.S., and the spike in oil to $110 a barrel in the first quarter created a very difficult backdrop for the U.S. economy. Chance, randomness played a significant role in causing us to question whether the U.S. economy is stabilizing enough in 2011.
But we’re not in a recession. The numbers prove it. The Gross Domestic Product numbers are nowhere near negative territory. If anything, the last revised numbers and the forecast have gone up instead of being pulled back down.
H.L.: Are stocks going to crash or is a Santa Claus rally in the cards, or a bear market rally?
S.P.: The equity market has already priced in a very difficult backdrop. Corporate profits will likely be sustained in this period. Margins are quite supportive. In fact, the profits backdrop is stable.
H.L.: Where are stocks headed?
S.P.: We think there’s support for equities. We’re still prisoners of what goes on in Europe, but if we see some stabilization, you have the makings of a classic bear market rally. It ties into seasonality. It ties into support for stocks in a historically low interest rate background.
H.L.: How are corporate fundamentals?
S.P.: They’re not bad. Corporations have trimmed down sharply. In the perverse backdrop we’ve got right now, companies have been scared to hire, and it’s allowing profitability to look stronger. The debate on valuations is whether or not you get top line growth or revenue growth when it bounces back that strongly. That’s still a very difficult backdrop.
The counterpoint to this story is that stock prices are also trimming back. Corporate profits remain quite reasonable. In the last quarter, we saw a fairly good stable of earnings surprises in the reporting period.
H.L.: Do any sectors of the stock market and the economy look good?
S.P.: We continue to see fairly decent consumer results. Some of the consumer numbers were good. We saw technology spending remaining fairly constructive. There’s more of a mixed bag on the commodities side, where we saw some supporting commodity trends, while at the same time some pullbacks as well.
H.L.: What would you invest in?
S.P.: We have looked at the semiconductor group carefully, and we recognized that the software valuations are at such an extreme, and the hardware valuations are quite depressed. So, unless capital expenditures completely collapse, we foresee the semiconductor group to recover nicely.
In addition, into this earnings season we think this is especially favorable, because sell-side analysts have been very aggressive in cutting estimates for the semiconductor group, harsher than usual. Right now we’re seeing almost 90 percent of all estimates for semiconductors are negative or cut. That’s about as dramatic as we’ve seen in the last 20 or 30 years.
Another area we’ve done some work in is retailers. This dates back to the inequality of income problem as well. In the focus of retailing, we really are seeing a “Tale of Two Cities,” where luxury retailers continue to do quite well, and we’re also seeing signs of increased demand for dollar hot dog packages as well. So you’ve got two very different trends.
From an investment standpoint our work suggests that we continue to focus on the luxury retailers, and, conversely, the discount and lower retailers are quite undervalued. However, we feel that could be a value trap. If unemployment marginally stabilizes, the focus will be on middle- to high-end retailers. Part of this has little to do with the U.S. In fact, when we looked at the luxury retailers, a lot of that support existed because of the global non-U.S. demand.
H.L.: Do you see unemployment staying where it is?
S.P.: We think it will marginally improve, but it’s just going to be very sluggish. It’s very unlikely to change drastically. A lot of it has to do with the sharp contraction in demand that most companies have felt the last three years. In that period it has been very difficult for business owners to say they’ve got to add to the labor pool.
H.L.: What about housing?
S.P.: We don’t see a housing recovery. The backdrop is very difficult. It takes years to work out. You’ve had some government support to prop up housing, and some of those supports are staring to fade, so you’re going to see a tapering off of the housing sector.