Much of what I read strategy-wise on the markets is quite wishy-washy. I saw an article yesterday from a respected strategist saying that if the S&P500 (SPY) breaks below 1290 (the 200-Day Moving Average) then look out below. But then, if it bounces above it, the markets are heading higher and it's time to put money to work.
In a nutshell he suggests that if the market goes lower, then sell. But if the S&P stays above 1290 and rallies, then buy the market. Sounds kind of like buy high, and sell low. Excellent advice! Not only that, but the article largely ignored the fundamentals altogether. Shouldn't a market strategist at least mention that Spain and Greece are on the verge of exiting the euro, leaving their banking systems in peril?
So, on the fundamental side, I read mostly bearish arguments. The panic in May was indeed palpable. Never mind that much of the bearishness was missing back in March when the market peaked. Yes, Greece is a mess. And while Greece and arguably Spain have been insolvent for quite a time, a liquidity crisis is now brewing again.
The problem I have been grappling with is, how does one invest successfully in a world governed by so many binary events? Nobody can predict whether the euro will survive or not. Simply put, if the Germans decide it's ok to print euros and bail out Greece, then we'll have a tremendous rally. If not, without doubt fear and uncertainty will push every risk asset lower.
The hurdles for Greece are seemingly high. Greece has to not only form a new coalition government after its June 17th elections, but also must pass 11BB euros of new austerity measures to collect on its July 1st bailout tranche from the troika (the IMF, ECB and the EC). That seems like a tall order. Doable, but this will come down to the wire. Continued fear and uncertainty seem highly likely.
From the German's perspective, if Greece and Spain and Italy go, then the resulting strength in the euro (yes initially it may fall), will likely mean that their export economy will suffer as a result of such a strong currency. Same argument goes if the Germans revert to using deutsche marks again. The mark would rally terrifically (or horribly!), so much so that the cost of BMWs and other German goods would go through the roof. Not good for an export economy like Germany. It wants to keep the euro alive, and weak.
As for the United States, surprisingly bad payroll numbers coupled with improving manufacturing data, provide an ambiguous outlook. GDP at 1.9% is weak-ish, and with the possibility of a fiscal cliff in 2013, which could impact GDP here by 4% (the bad way), economically we also are facing a binary outcome. Can a lame-duck Congress pass measures to extend the Bush-era tax cuts between November and early January?
What is certain in all of this is that nobody knows the outcomes of Greece, or the U.S.'s fiscal cliff issue. These are politically unpredictable. We can try to put probabilities on them, but it's a fruitless task. I have tried. Perhaps others out there know whether Germany blinks on saving Greece or not, but I don't. (I don't think even Angela Merkel knows).
I also find it fruitless to spend a lot of time pontificating on what the Fed and the ECB should do. Do you really care that I think they should let the Greeks go, and perhaps even Spain? I would have cut them loose two years ago. I would also raise interest rates here, but that is another discussion altogether.
The other certainty however, is that central banks will support the banking system. As I have said many times, no central banker anywhere in the world is dumb enough to let another large (or even medium-sized) bank go bankrupt. Spain just last week bailed out its third-biggest bank, Bankia with 19BB euros in capital.
When the U.S. allowed Lehman to file Chapter 11 in the Fall of 2008, it was sending a clear message that the Fed would not encourage moral hazard (i.e. banks take on too much risk, taxpayers take the fall).
However, Fed officials today confess that they didn't foresee the contagious damage that lack of faith in the financial system can cause. (It now seems that the correct path to banking stability is not to scare banks into avoiding taking on too much risk, but to regulate them with higher required capital levels and limited proprietary trading).
That said, the key to investing again in this market will be to watch the ECB and the Fed. They will eventually step in with support. Perhaps not to keep Greece from leaving the euro, but they will provide unlimited liquidity to the banking system. Failure there is not an option. And when support comes, it will be time to add exposure.
So what are the Central Banks around the world doing and saying now?
Yesterday, the ECB's Mario Draghi stated:
Today we have decided to continue conducting our main refinancing operations at fixed rate tender procedures with full allotment for as long as necessary and at least until the end of the 12th maintenance period of 2012 on Jan 15, 2013.
Last October, the ECB offered unlimited central bank funding until July 10, of 2012. Now it's offering unlimited funding until next January. It didn't lower rates at its meeting this week, but then again, what difference does a 1% or 0.75% rate mean? Not much. But offering to provide unlimited three-month cash to European banks is important.
In the U.S., Operation Twist has provided very little real benefit to the economy, but its impact on the markets has unquestionably been positive. QE1 and QE2 similarly offered tremendous equity support.
Naturally, when you force investors to swallow near zero percent on banking deposits, they look elsewhere for yield and return. Much of this money flows to equities. Operation Twist has even taken out the return on long-term Treasuries, meaning now long duration government (and investment grade) bonds offer little in the way of yield. Retirees must hate Ben Bernanke.
There are signals that the Fed may be willing to extend Operation Twist (it ends this month). I don't know how effective any kind of Fed easing is from an economic perspective. But without doubt the policy shifts investors into riskier assets to generate yield or return on savings. History also seems to show that markets rally when monetary policy is accommodative.
Focus on Risk Reward
My investing mantra is to always manage risk and reward. I recently bought JP Morgan (JPM) for instance. I feel that at $32 a share (under tangible BV/share), the stock offers $5-$7 of downside, and $20-$25 of upside. I cannot predict if the market continues to sell off this summer, but barring a financial meltdown (which I just wrote seems highly unlikely), JP Morgan likely continues to generate high returns on capital (15% last year), and trades at historical low valuations. This seems a buy.
Am I keeping a little cash to buy more if it falls to the mid $20s? Yes, absolutely.
If I try to macro analyze the world, taking the S&P500 for example, then it does seem that the risk reward isn't great, but isn't terrible either. Sure, bears argue that the S&P has been an awful performer over the last decade. But in 2002, stocks traded at over 30x earnings. Today, the S&P is trading approximately at 13x 2012 earnings. For the markets to perform as poorly over the next decade, the S&P will have to trade to 5.6x earnings in 2022!
Ok, but what about the fact that margins are much higher today, and will fall in the next recession? Valid point yes. The so-called Shiller PE10 ratio, which uses a 10-year look back period to normalize margins, suggest that we are at a 20x P/E ratio, compared with a historical average of 16x.
My beef with this metric however, is that it simply ignores the fact that margins likely will stay higher in this environment. Wage pressure is largely non-existent, and interest rates (a big driver of margins), will continue to stay low. At least until 2014, according to Fed policy.
So, yes, slack demand may cause some margin pressure, but on the whole, corporations have more cash than at any time in history (i.e. less net debt), so until that changes, margins likely remain better than history.
In fact, it may be a decade before wage pressure and inflation (which lead to higher rates) become a problem for corporate margins. Globalization of the labor market, excess labor supply and intermittent bouts of deflation are not problems that go away within a year or two.
The Greeks are clearly running out of money, and if Germany decides it does not want to support them, then a "Grexit" will likely lead to a sell-off in the markets. To me that says, I have to keep some dry powder. However, the S&P has already taken an 8% hit, and emerging markets are down 16% from the peak in February. That suggests some assets are cheap, and worth buying now too.
To put some numbers around this, I suggest that the markets are half way through the summer sell-off. We may fall another 8% on the S&P, but if we get to 1200 for example, the S&P would be trading at 12x earnings, or an 8.3% Free Cash Flow yield. These are attractive absolute investment levels, especially given that 10-year treasuries are under 1.5%. I will be back to full equity exposures if we fall another 8%-10%. I am 60% exposed now.
Overall, valuation matters most to me. I think at 1200, equity reward unquestionably outweighs the risk. Consider adding exposure gradually over the summer as we approach that level. Conversely, at 1400-1500 I will take down my exposure another 10%.
For some perspective, today's S&P multiple (about 13x) implies a 7.7% FCF yield. Back in 2000 when investors were frantically piling into stocks, FCF yields were a paltry 2.3%. Put differently, stocks were clearly overvalued back then at 44x earnings.
Some exposures you have to avoid too. There is little question in my mind that the risk reward to owning U.S. treasury bonds is abysmal. Who wants to lock themselves into making 1.6% a year for a decade, when inflation here is running at 2.3% (April 2012 annual rate)?
My bond exposure is almost entirely corporate, both in bonds and bank debt. Municipal and Federal balance sheets look terrible to me, not to mention the return isn't there either. Lots of risk, little reward. The deflationists' view of the world seems not supported by the facts either. Look at CPI (from the BLS website) for the past 5 years.
Where is the deflation? More likely low U.S. Treasury yields are signs of a bubble as well as a result of an overabundance of loose monetary policy.
I admit to owning some agency exposure, but recommend corporate and emerging market bonds as far better investments than U.S. or even German bonds. Balance sheets are far better, growth far stronger, and yields much higher than in the G-7 countries. What is not to like?
Now doesn't seem the time to reduce exposure anymore. I sold a number of names like Apple (AAPL) and Microsoft (MSFT) earlier in the year. I also sold puts on some names that had run up, a couple of which expired worthless, thereby reducing my cost basis. I am looking now to gradually increase risk exposure over the summer, and recommend adding to equities when the market is down. I did buy back Apple for example in May, as well as a new position in JP Morgan as discussed. Recently, I suggested looking at these five stocks trading at six times earnings (here).
Greece is a $300BB economy, slightly bigger than the GDP of my home state of North Carolina. Even if some of its banks go, I don't think contagion is big enough to sink equity markets as badly as in 2008. The U.S. housing debt market is $10TT in size, absorbing the losses there meant banks long mortgage paper suffered well over $1TT in losses.
I hear the contagion argument for Spain and Italy. Spain's GDP of $1.3TT is sizable, but compared with the world's GDP of $65 Trillion, still isn't large enough to derail world GDP growth. In fact Spain is already experiencing a recession, with 24% unemployment and GDP forecast to fall 1.5% this year. Its balance sheet is in fact better than that of the United States, with Debt/GDP of around 80%.
If Spain were to be recapitalized, I would suggest that its roughly $1.0TT of debt could be backstopped successfully with 200-300BB euros of ECB (or EC) capital.
What about China? Its economy is slowing rapidly, and stimulus measures aren't likely to happen until the Fall. Nor are stimulus levels expected to be nearly as large as they were in 2008/2009. That said, China is still expected to grow GDP by 7.5% to 8.5% in 2012, a level that shouldn't induce too much concern.
There certainly is a lot of risk out there, but nothing to me screams out a repeat of our last financial crisis. Not with central bankers better prepared to print currency to monetize bad balance sheets. Admittedly European banks are in scary shape. But I view any panic sell-offs as offering good opportunities to add equity exposure. Stay tuned.