Are We On the Verge of a Rally?

Will the ensuing rally come?  If it comes, will it be a bear market rally?  Or, perhaps a V-shaped turn around?  Or, possibly a long U-shaped recovery?  What about an L-shaped recovery? 

In my view, we can look for a fairly sharp rally.  Whether it is a bear market rally, or the start of recovery depends on implementation of the bailout package.  In my view, we can expect a U-style recovery. 

To determine where we are in the present cycle, I look at Consumer Confidence, Unemployment, GDP, Industrial Production, Real Interest Rates and the Yield Curve. 

Consumer Confidence looks like it has recently bottomed out (click on chart, below):

Unemployment has been rising over the past year.  And it continues to rise; during August the rate rose to 6.1%. 

In terms of where we are in the present cycle, GDP growth has been 2.3%, 3.5% and 4.1% in current $ and -.2%, .9% and 2.8% in chained 2000 dollars.  During 2007 and thus far during 2008, annualized inflation levels have remained elevated at over 4%; thus GDP growth adjusted for inflation has been negative three quarters running. 

Industrial production showed signs of stabilization during June and July, but contracted sharply during August; on an August 07 to August 08 basis it is down 1.5%. 

Real interest rates are in negative territory while the yield curve has steepened with short term yields nearing 0%. 

In normal circumstances, rising consumer confidence after a significant fall is indicative of an economy in full recession.  Industrial output continuing to fall indicates early recession; it will typically bottom out during full recession. 

Three quarters of GDP contraction is indicative of being in full recession.  Real interest rates falling are also indicative of an economy in full recession.  A normal yield curve (short term yield less than long term), is indicative of full recession.  A steep yield curve such as we see today, is normally indicative of early recovery; I suspect that the steep yield curve today is more a function of sheer terror in the financial services sector than of the stage of recession. 

People will accept no yield on a short maturity, not so much in anticipation of better upcoming opportunities; the instinct is capital preservation.  On balance, I would conclude that the economy is in full recession.  It is likely well past the beginning and early contraction and into the middle late contraction; perhaps poised to enter the late stage of contraction. 

The late stage of contraction within an economic cycle will typically last six months.  This time around I believe that it could take considerably longer. 

For our economy to recover, the first sector which must heal is financial services.  With the bailout package now likely to be enacted, the healing process has begun.  The length of time spent in the healing process will be influenced by the effectiveness in implementation.  In addition, the problems are of such historic significance, that despite the bailout package, I cannot contemplate a quick turn around. 

During the late contraction stage of the economic cycle one normally looks for out-performance in financial services.  It is also a good time to search for cyclical and secular trends which determine the key drivers of the next economic cycle, for these are sectors where significant out-performance can be expected. 

This time round, there are cyclical secular and cyclical themes pointing to significant out-performance in basic materials, industrials and energy.  However, there is a powerful adverse force in the state of the financial services sector. 

The de-leveraging in financial services, together with large reductions in the size of the derivatives market (estimated at $62 trillion) can meaningfully impact basic material and oil prices; this in my view will create an excellent entry opportunity as the strength in these sectors is strongly demand led. 

During this cycle, sectors with dependence on leverage (discretionary & financials) can also be expected to under-perform.  Finally, growth, which is also dependent on leverage can be expected to be out performed by value.  My sector calls are noted below.

Financials (Avoid) are presently priced with a healthy respect for solvency risks in addition to liquidity risks associated with the market.  The little information available on the bailout package indicates that solvency and liquidity risks will recede. 

Thus on an enterprise value basis, we can expect to see an improvement in financial services.  Financials should outperform.  Now for the depressing news - this does not mean that the present owners of financials will prosper.  There are no free rides - the warrants likely to be granted to the government will lead to significant dilution and it is likely that owners will lose even while the sector enterprise values strengthen. 

In addition, do not expect massive credit expansion. Growth opportunities in this sector will be low as it de-leverages to shore up capital adeqacy ratios.

Information Technology (Outperform) are likely to outperform.  Valuations are not unreasonable and balance sheets are very healthy; even under-leveraged.

Consumer Discretionary (Avoid) The risks remain elevated.  The US consumer remains over-leveraged. 

Asset price deflation will continue - home inventories in the United States have risen from lows of 4 months supply to near 20 months supply; and this despite asset price deflation of over 15%. 

As credit markets ease, inventories can be expected to start declining; but in my view not without further considerable asset price deflation.  I expect peak to trough declines of over 30% as the housing market unwinds.  Significant risks are priced in and so there is potential for out performance, but the sector risks are elevated.

Materials (Neutral) The sector remains one with very strong demand-led fundamentals.  However, there is a $62 trillion derivatives market out there which needs to unwind. 

There is also a need for further de-leverage of financial institutions to strengthen capital ratios.  Further price reduction can be expected; but the extent of reduction should be limited due to (a) expected incremental demand from industrials (b) recent price reductions have already occurred.  I would rate this sector a hold with accumulation on further price reduction.

Industrials (Outperform) Once more a sector with excellent prospects.  The balance sheets of corporate America remain strong and under-leveraged.  At the same time growth opportunities abound.  Valuations too are not unreasonable.

Energy (Neutral) The sector remains one with very strong demand-led fundamentals.  However, there is a $62 trillion derivatives market out there which need to unwind.  There is also a need for further de-leverage of financial institutions to strengthen capital ratios. 

Further price reduction can be expected.  Because of strong secular trends, I would hold and add to positions on significant price declines.

Health-care/Staples/Utilities (Outperform) I believe de-leveraging will shift money flows to defensive and sectors.  Income investors are likely to turn to dividend yield too.  Of the three, I like health-care best, both for its yield and prevailing valuations.

Disclosure: None

Comments

[venividivici:]

God help me!!!!!

2008 Sep 29 04:17 AM

[pochovilla:]

You're describing a LUV rally. Like the lowly fraternity brother who was blind drink, unshaven and sweaty and passes out in a bed to find he wakes up with with an ugly fat girl the next morning. Did they make love or will this turn out to be a bad dream with consequences?
Veni summarized it quite well.

2008 Sep 29 04:55 AM

[phdinsuntan...:]

goood intention, bad timing: de-leveraging in financial services and large reduction in the size of the derivatives market can take a while, in the meantime your IT and Industrial stocks will get a ride southern sri lanka

2008 Sep 29 09:30 AM

[OilyGasMiner:]

Shiv, Interesting perspective on where we are in the economy. I agree with most of your points except your views on financials and energy. I believe we will see a strong rally in energy in the shorter (next 3-6months). I say this as we will experience some inflationary pressure leading people to head to precious metals and the black stuff in anticipation of capital preservation. In addition regarding financials, I do believe we are nearing the bottoming out of these equities, and given their undervalued state, we will see a huge bounce within the next (8-12months) as consumer confidence is increased which is greatly influenced by the success of the bailout, which I think is the pivotal point in determining the ultimate rally that will ensue. , Further Due Diligence<br>

2008 Sep 29 12:14 PM

[OldLimey:]

OilyGasMiner: "regarding financials, I do believe we are nearing the bottoming out of these equities, and given their undervalued state..."

Help me out here - how DO you ascribe value to a financial at the moment? Balance sheet numbers are in the process of moving from questionable to meaningless (courtesy of the Bailout). Sounds more like spinning the wheel than value investing.

2008 Sep 29 01:22 PM

[Timothy Stolz:]

Shiv,
Since the economy seems to be heading into what some pundits are calling a "severe recession" if not the early stage of a depression, where would today's stock market downturn likely be charted on your U shaped curve?

2008 Sep 29 11:16 PM

[Jake2:]

The author lives in never-never lotus land. Follow him not.

2008 Sep 30 12:48 AM

[Shiv Kapoor:]

Timothy - We are in the middle late stage of contraction now. To move into the late stage, financials needs to restore its health. An extended stay in the middle late stage would mean a hard landing (severe recession/depression). Personally, I expect the next six months to be the healing period, unless the government is foolish and does not act at all. If there is policy failure, it is difficult to estimate how long it would take financials to heal itself - I would look at late next year to proceed to the early expansion phase; by this time you could find the DOW somewhere between 7500 and 9400. But I expect the healing to start about now with a final cycle bottom somewhere between 9,800 and 10,500 and the start of early expansion during q2 09. Risks remain elevated read maxkapital.wordpress.c.../ so maintain defense (health-care/staples) until there is clarity on policy.

Keep in mind that the next economic cycle might be somewhat anemic for the broader market; this is a cycle when I expect to see a global trend for capacity creation to facilitate the next stage of expansion (this is why I remain long term bullish on materials & energy). The following cycle, is when you can expect to see utilization of created capacity come into use to generate earnings growth which can drive the broad market.

2008 Sep 30 05:18 AM