After the usual rip-roaring first day start to 2012, one driven largely by new equity mandates being put to work, one may very well be wondering what to expect next.
As a rule, January has that element of fresh start that resembles the time around the beginning of a new season for a sports team. Previous sins and disappointments are forgiven and forgotten, at least for a few weeks. And if they're not quite forgotten, well, at least pushed aside for a time while the fans and punditry put forth their hopes of what could go right. Player A is feeling better this year. Player B has recovered from surgery. Another hopes to return by mid-season. The star that had a bum season last year will return to form, while the bum who had a star season will keep it. The manager has a new strategy, the general manager has a new assistant, and the owner has a new dog.
With that in mind, let's review this year's new-old pop slogans, beginning with the bull side:
- The U.S. is the cleanest dirty shirt
The central tenet here is that U.S. growth is mildly positive, while Europe is headed into a recession and Chinese growth is slowing. The U.S. as good-but-not-great safety play may be the most widely held belief in the investment world, and that alone ought to make you uncomfortable. If we hear this cliché one more time, violence may ensue. After reading about the U.S. economy below, you may be prompted to replace it with another hoary cliché - "where's the beef?"
- Treasuries and tax-free municipal bonds look great
The main rationale for either of these is the oldest one on the Street - they had a good year last year, so why not this year too? But treasury bonds have almost zero margin for error at current prices, so to be consistent, any rational belief that the above is true has to agree that it's no time for equities. It's not really a bullish call but a momentum one.
Treasuries confounded bond legend Bill Gross this year, primarily because he was thinking like a bond guy and didn't appreciate the safe-haven mantra that equity traders burned into their skin during the crash of 2008. If you are certain Europe is going to crash, then holding Treasuries makes sense, but the time to reap the rewards may be surprisingly brief. They're overbought.
Tax-free municipals had their usual strong finish, thanks to the auction calendar, and were helped along even more by an unusually weak beginning to the year, precipitated by an out-of-synch auction calendar and panic selling started by analyst Meredith Whitney's infamous prediction of carnage in the municipal markets. They are starting this year at relatively high levels, so let the buyer beware.
- Emerging markets are cheap
They were supposed to be cheap last year too, but got hammered when the great growth rapture of 2011 turned out to be as disappointing to its adherents as that other rapture. If Europe or China mess up, EM equities will sink even further. However, if there is a positive denouement across the Atlantic, then EM will be one of the places to be, for the simple reason that their less-liquid markets will inflate faster as money rushes back in.
- European equities are undervalued
This is one of the sleeper calls. Many have noticed that multiples on large-cap European companies are trading at the low end of their historical ranges, hence the lure of this somewhat contrarian call (another appeal). It's a binary trade - if Europe goes to the abyss and/or gets it wrong, equities will get much cheaper. If the EU pulls it out, it'll look brilliant.
- Homebuilding is going to recover this year
This one has come out every January since 2007, and eventually it's bound to be right. It's true that it's hard to see how homebuilding could get any worse absent a financial panic, as inventories and production levels are quite low. On the other hand, so long as the 20% down payment remains the norm in mortgage-land, this market isn't going anywhere beyond the same this-time-is-different first-quarter trade.
Onto the less popular bear side:
- Another recession is about to happen
There are some high-powered figures warning on this one, ranging from Pimco's Mohammed El-Erian, who puts the chances at thirty to forty percent, to George Soros and the Economic Cycle Research Institute (ECRI). The Street likes to dismiss Soros as an aging liberal past his prime (except when he's bullish), but Pimco and the ECRI are very data-driven outfits. Niall Ferguson is in this camp too, but he's from the UK and teaches at Harvard, so he can't possibly be right.
- Investor sentiment is at a peak
It can't be denied: markets are a bit overbought, and sentiment measures have risen sharply into near-giddy territory. The best that can be said against this is that markets can stay silly for much longer than you think, and that the best times for giddiness are the beginning of the year, the end of the year, and April.
- Corporate profit margins are going to revert to the mean
It could happen - certainly the rate of profit growth has slowed. That said, we expect that about two-thirds of companies will beat estimates in the coming weeks, because two-thirds of companies beat estimates about 95% of the time. The fact that the estimates have again come down sharply, as they did for the second and third quarters, will be observed by a few and pushed aside by the many.
Can't argue this one. It's THE swing factor of 2012. If the EU stumbles - and it might, as one can never count on rationality with political decisions - then equities will be out of fashion for a time. That said, less than a meltdown is probably already baked into prices, and many will be hoping to range-trade a muddle-through type of situation. The price signals on this might not make any sense at all.
What to do? We think that the coming earnings quarter is going to be hard-pressed to keep up the facade of “all is well,” and would sell strength through the next couple of weeks, at least until the month-end mark-‘em-up rally. Use those ringing bells to ring up profits and put more cash in the drawer.
And the economy? Well, the December jobs report beat expectations with its official estimate of 200,000 new jobs, but failed to excite the Street. Part of the problem was the ADP report the day before: it estimated 325,000, or more than fifty percent larger, much as it did a year ago. The markets didn’t bite quite as much this time around, but even so our reading of the tape was that the ADP news helped keep a bid in the market on Thursday, which might otherwise have vanished in the face of European pressures.
It also didn’t help that the details didn’t add up to the most robust-looking 200 G’s ever seen. As news spread through the market that 42,000 new positions were in the form of messengers and couriers, added chiefly to avoid paying overtime to existing delivery staff, the elation over the beaten consensus (around 150,000) faded. Recent history suggests that all 42,000, plus a few more for good measure, will disappear in January. Temp jobs, usually thought to be a leading indicator, contracted for the first time in months, and the household survey’s gain, though still at 176,000, has been shrinking and was the smallest since July. It also compares poorly with last December’s gain of 283,000.
The report was all right enough in that it showed a continuation of the moderate gain trend, but there was no sign of a breakout. The average workweek edged up to the top of the range it’s been in all year, while hourly earnings moved up a few cents. The aggregate payroll index, a good clue to personal income, did move up by a healthy 0.7%. However, the revisions have tended to the downside, so we estimate that it will end up being closer to plus 0.5%, along with personal income. If form holds, that will be followed by a flat-to-down January.
The revisions to October and November added up to a net loss of (-8,000), not a big number but significant for those who believe that the direction of revision is the most important leading indicator in the report. Stories about potentially sizable impending layoffs from PepsiCo (PEP), Boeing (BA) and Alcoa (AA) also checked urges to celebrate the good news.
Perhaps the best news was that the unemployment rate fell to 8.5%, against expectations for a slight increase. Even a subsequent revision back to 8.6% wouldn’t be bad news. It’s true that the labor force keeps getting smaller, but the improvement in trend is undeniable - the unemployment rate for the college-degreed segment has fallen from 4.8% a year ago to 4.1%, the over-25 rate has fallen from 8.0% to 7.2%, and even the worst-off sector, those who failed to finish high school, has fallen from 15.1% to 13.8%.
That said, neither employment nor income are keeping up - the work force is only 200,000 larger than a year ago, and the year-on-year change in disposable personal income has been running negative since July. No corner has been turned - we're just getting better a little bit at a time. Political tampering could easily derail what modest momentum there is. Or should we say was? - the ECRI weekly index just declined for the eighth week in a row.
The ISM reports were in the same vein. Although the manufacturing reading seemed to mildly improve with a 53.9 reading compared to November's 52.7 (fifty is neutral), the ratio of growing sectors to contracting ones remained tied, at 8-8. New orders improved slightly to a 57.6 reading, but there too the score was mixed, with nine industries reporting an increase and seven a decrease. Japanese investment bank & strategist Nomura put out a note (posted here on FT Alphaville) saying that some of the better known surveys, including the two ISM editions, are overstating seasonal factors in quarters four and one because of the depth of the 2008 recession in those two periods. That’s consistent with the gaps between initial and final estimates of GDP for those periods.
The non-manufacturing index (NMI) was largely unchanged from its previous reading, at 52.6 in December versus 52.0 in November (the ISM will tell you that such differences have little significance). There was no indication of employment pressure, with another neutral reading, but some analysts mistakenly suggested that that contradicted the BLS report showing service jobs increased. The ISM report is geared to large firms, and the BLS report reported more than half the gains coming from small business. We would add that the best momentum indicator in the non-manufacturing report is the price index, and it reported a mildly lower number in December.
Factory orders, like the NMI, were positive but below consensus with an increase of 1.8%. Shipments, which factor into GDP, were unchanged in November (so far). The month was clearly something of a lull, with new orders excluding transportation up 0.3%, but business capital spending down for the second month in a row. We expect both categories to improve in December as businesses move to take advantage of the expiring accelerated tax credit, followed by another slowdown in January.
The FOMC minutes didn't really clear up much, and the committee may come to regret its plan for more open communication. Some are betting that its plan is just a way to soften U.S. up for QE-3 - but before you get your bets down, either a recession or European meltdown will probably need to happen before the Fed goes out on that limb.
This week brings U.S. a lighter schedule. The spotlight may end up on JP Morgan (JPM) on Friday. Alcoa announced a 12% global capacity cut last week, so expectations weren't high for its earnings miss. But JP Morgan needs to deliver.