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Consolation prizes for 2011

The first days of each year provide an opportunity to draw up a more or less detailed forecast of the major trends that can be expected for economies and financial markets in the next twelve months. Like all New Year resolutions, these forecasts will for the most part be, if not abandoned, at the very least sharply revised during the year. 2011 is no exception to the rule and the major themes that have punctuated my holiday reading can be summed up in a few lines:
1. On a scale from extreme complacency to excessive pessimism, it is optimism that generally prevails. By and large, observers are very confident about the stock market, the US recovery and continued robust activity in emerging countries. They believe risks exist, but that they are more or less well reflected in prices.
2. The (not exhaustive) list of the main risks is as follows: a fresh European crisis and a Spanish default; inflation out of control in China accompanied by a drastic monetary tightening; a rise in commodity prices that could lead to widespread social unrest; a sharp rise in sovereign interest rates reflecting inflation risk and a deterioration in public finances; a persistently high unemployment rate in the United States and a fall in residential property prices (with a possible negative impact on bank balance sheets); a lack of cooperation at an international level (just when France is taking over the presidency of the G20); the appreciation of the yuan is also mentioned, but is this really a risk?; the spectre of a US municipal crisis is also turbulent; all your suggestions are welcome at the Comments page.
A bumpy and volatile year has been announced almost everywhere, which is a way to say that these risks will follow one another, and sometimes pile up. However, this does not mean that an overall disaster is drawn on in the main scenario (we could discuss at length the advantage in having alternative scenarios).
So it is always possible to find arguments to justify one’s own view. I read a comment on a famous blog announcing an unpredictable event, a "black swan".
To hedge their bets, others talk about a grey swan. Others, finally, prefer focusing on non-forecasts for 2011.
Beyond simple forecasts, maybe it is more interesting to identify the investment themes. There are several such themes in the stock market, and it is probably on this subject the discussions are most lively.
1. The illusion of the past: because there cannot be any annual forecast without more or less reliable historical examples, this year we offer an election axiom: "the first six months of pre-electoral years during a first presidential term historically provide very high performances". We will find out whether the good relationship between the Republicans and the Democrats that prevailed during the so-called "lame duck" parliamentary session will prevail in a context of high unemployment, municipal crisis, etc.
2. Valuation versus Momentum. Momentum describes the markets’ capacity to extend a trend (up to the 2007 highs?). There can be many causes, from passion among some, the determination to catch up among those who believe they have "missed the boat", and, obviously, attractive valuation. The simplest - and generally most advanced - calculation to forecast the end-2011 level of the S&P 500 is as follows: earnings per share (NYSEARCA:EPS) is currently (for 2010) USD 83.6 (S&P[1] data) and the growth consensus is close to 13%, i.e. USD 94.8 (a growth well below last year’s level, which was close to 50%, after a catastrophic 2009).
It is at this stage that valuation analysis comes into the picture. The conventional reference is the PER, i.e. the price-to-earnings ratio, which is supposed to fluctuate around its average in line with the cycle. There is a heated debate between:
i.                             The proponents of the CAPE, the PER adjusted for the cycle calculated by Shiller, which relates the current price to average past earnings (10 years). It currently stands at[2] 22.72, i.e. well above its long-run average, suggesting that equities are expensive.
ii.                           Those (I am one of them) who believe that valuation must apply to future flows and that the current price should rather be related to expected earnings. According to this metric, theforward PER is 14.5, i.e. well below its historical average. It could exceed it somewhat for a few years without there being a bubble. By using the previous calculation, the combination of an EPS of 94.8 and a year-end PER of 14.5 would bring the S&P 500 to 1,375, i.e. an 8% rise in year-on-year terms.
Some analyses go as far as predicting the timing of certain risks. For some analysts, the European stress test scheduled for February could precipitate the Spanish risk. For others, the analysis of market sentiment could be associated with a chaotic beginning to the year.
3. Return to the average and contrarian strategy: there are numerous measures of investor sentiment. Among these, we find the AAII index (% of investors betting on a bull market) and the Put/Call ratio (the lower it is, the higher the number of buyers of call options). Both can be seen in the Chart below. They are at their most extreme levels since the crisis. Combined with falling volumes (down 15% from 2009), many believe these developments suggest that in spite of a fundamental bullish trend, a correction is possible at the beginning of the year. The recurrent investment theme is therefore the famous buy on dips. Technical analysis will be of great help.

4. Relative returns: the main argument used by those who are long equities is the comparison between long-term interest rates on 10-year US Treasuries and the return on stock market indices. We know that this latter is made up of the dividend rate and the capital gain. Many “bulls” have until now emphasised that the dividend rate (close to 2% on the S&P 500) was attractive on its own, given the low level of 10-year interest rates. Since the introduction of the Fed’s QE2 (second wave of the Treasury bond purchase programme), the US 10-year interest rate has risen by 100 basis points, making the argument obsolete (especially as in absolute terms, a low dividend rate would rather tend to indicate that equities are expensive).

So the arguments are now based more on a rationale of flows than a rationale of compared returns. Investors talk about "bond market watchers" who are apparently concerned about the return of inflation and the explosion of sovereign debts.
The Chart below is taken from the site of ICI[1] where we can read that over the last few weeks, investors have massively pulled out of funds invested in the bond market. It shows that their memory is persistent and that since the collapse of the indices in 2007, the cumulative investment flows into equities have continuously declined.

The key argument of the "bulls" is that investors will once again arbitrage in favour of equities – by default in a way. Even though this argument makes sense, the risk of a bearish bond market should not be overestimated: even though US growth may be stronger than expected in 2011 (if GDP is up 2.7% and inflation is 1.3%, the target for US long-term interest rates will be 4%, i.e. a drastic normalisation, but not a crash), the inflationary pressures remain very limited. The risk of mistrust of public debts remains intact, but: i/ global liquidity remains high and combined with the Fed’s purchases, the traditional arbitrage between assets is far less relevant; ii/ private economic agents are deleveraging (companies have primarily substituted "market" debt for bank loans), which ought to limit the so-called crowding-out risk.

The new year does not change the macroeconomic state of affairs. Il only resets the counter for investors judged on their annual performance. Many macroeconomic risks remain, and they are not easier to rank than before Christmas. At this stage, it is not incoherent to use trend extension as long as nothing really new happens.

However, the main risk is perhaps the view on risks and opportunities for 2011, which is a little too consensual. It is not necessary to have a different, extreme view at all costs, but the beginning of 2011 is characterised by a very long list of risks for which there is no consensus. Also, none of these risks, taken individually, gives grounds for a pessimistic view.
In former times, a certain caution would have justified a certain rebalancing, for example, betting on:
An outperformance of CAC over the DAX after the latter has "benefited" from the European crisis?
Lower performance for small caps (the Russell 2000 has outperformed the S&P 500 by more than 20% since the 2009 rebound)?

A more favourable arbitrage in favour of equities against credit (see Chart below, which compares the interest rate on a BBB corporate bond with the dividend rate of the S&P 500).

Will Asia’s comparative advantage persist? The two Charts below show a trend break in the correlation between the S&P 500 and the Shanghai composite on the one hand, and between the Shanghai composite and copper prices on the other hand.

There will certainly be a return to the average, but in what direction?
The case of commodities and the dollar remains a major theme: a pure cyclical approach should benefit the dollar, as US growth has been revised upwards by almost one percentage point for 2011, while the euro zone will be suffering (fiscal consolidation) and Asia could slow down more than expected under the double effect of China and attempts to combat inflation and capital inflows.
However, one of the "certainties" solidly entrenched in the forecasts for this year is that oil prices will very soon exceed USD 100, with 110/115 as a target. Such a development is possible and could be compatible with a stronger dollar, but as shown by the Chart below, it can hardly last.

For the "fundamentalists" who primarily focus on excess supply, the recent trend remains a mystery: global stocks stand at 20 days versus 14 at end-2007 – when prices for the first time hit the current levels; likewise, the excess capacity is still estimated at close to 4/5 million barrels per day. Obviously, the arguments of liquidity, inflation risk and prospects of rapid catching-up by emerging countries remain valid, but unlike certain metals, the issue of supply and demand is unlikely to be significant.
2011 is a year that combines many risks and unclear macroeconomic trends. This lack of directionality (no noteworthy change in monetary policies, no drastic adjustment in growth rates, etc.) should give grounds for caution and will undoubtedly imply frequent portfolio rotation.