It’s been a volatile week. Bond market action implies that investors are rapidly losing confidence in the ability of Italy and Spain to pay off its debts in the long run. It took massive ECB purchases to tame the yields to a reasonable level (below 7%). We also saw the euro fall below the key 1.35 level relative to the dollar, which was the bottom we hit when George Papandreou was scaring the heck out of the markets with his referendum idea.
Due to this, there’s been a lot of deflationary pressure inducing declines on the stock market, combined with more risk-aversion. The S&P has been brought back below 1220 for the first time since October as a result of it. The foreign exchange market has also seen major pain in commodity currencies as a result, driving the highest yielding major currency (the Australian dollar) to parity with the US dollar. The Australian dollar is a pretty good way to measure the risk appetite of the largest financial institutions in the world (like central banks and huge banks looking for reserve assets), and if the AUD/USD pair is any indicator it can be said that the biggest players are sticking strongly with the dollar in these uncertain times.
As you can see from the price action, almost all of the “hopium” generated by the Greek bailout through the EFSF has worn off. We are once again worried about a catastrophic financial event in the eurozone as confidence wanes and people are skeptical that the ECB has the willpower or the means to do much more in this situation.
As a result, yields on Treasury bills have been whittled down to deflation levels again. The stock market’s correlation to the risk appetite in currencies has been startling, so just as people have flocked to the greenback, we’ve seen subsequent declines in the stock market.
These yields are, quite frankly, ridiculous. While inflation has remained relatively tame recently, CPI data released last week suggests that it’s somewhere near 2% annually. If you include food and energy into the equation, it’s closer to 3.5%. Even with dollar strength and a slow global economy driving down prices, the 10-year Treasury bill is basically pricing in 1.5% deflation for a decade. The 30-year Treasury bill is pricing in roughly .5% deflation for three decades. If you look at the picture, it simply doesn’t add up. There’s no way that the nation running the largest nominal debt in the world can afford deflation on that kind of timeframe.
The larger financial entities have to constantly worry about liquidity, which makes the short term moves in Treasuries more reasonable, but the appreciation of the dollar is getting out of hand given the fundamentals of the global economy. Since they’re so strong, now is really the time to be putting those dollars into the purchases assets like stocks. Not only do you benefit from a huge positive spread between equity yields and fixed-income, but you get something that will quickly move upward due to its intrinsic value in a weaker dollar environment. Then there is revenue and earnings growth, which has generally surpassed GDP growth and inflation by a large margin.
At the same time, shorts run the risk of large-scale intervention by central banks. They really have no problem doing what they think is best for the big picture. More fiscal/monetary stimulus measures are most likely on the horizon. Nobody (except maybe China) wants a strong dollar, because its appreciation is a sign of intense risk-aversion. Bernanke, among others, is most certainly looking to bring the financial markets back to the optimistic tone we had at the start of the year. The QE3 button is sitting at his desk, and if financial markets get distressed I don’t believe he’ll have a hard time convincing the other board members to proceed with it.
We all know that the eurozone is dead money for the next few years due to continuing austerity measures and a general lack of productivity, but I think we’ve drastically exaggerated these effects on outside economies like ours. Companies aren’t all that stupid, and they’ve been chasing the growth where they’ve seen it. Despite the recent slowdown, there are wildly bullish demographic trends that should be considered here. For instance, you have millions of rural Chinese who are still demanding the common products and services us Westerners take for granted. You have huge growth of the Indian population which will bring huge potential in revenues for well-positioned companies, and so on.
On top of all of that, we have demand coming back in the largest consumer economy in the world. US economic data has been improving tremendously, even in the housing sector.
- US jobless claims on 11/11 were 388K, much lower than expected. Since this is one of the biggest statistics that recession-callers have been using to justify their case, positive movement is very encouraging at this time.
- The US trade deficit has been shrinking. In September, it shrunk to $43.1 billion relative to the expected value of $44.9 billion. Keep in mind that this was in a strong dollar environment. It will get even better as the dollar gets weaker over time.
- US Building permits in October came in at 653K, relative to an expected 589K. Any significant increases in big-ticket purchases should be taken seriously, because they represents particularly large spikes in consumer/business optimism
- US industrial production in October came in at a .7% increase. Most were expecting a decrease. The indicator measures in real terms, meaning that it hasn't benefitted from any inflation
Keep in mind that this data is coming at a time when banks are extremely hesitant to loan money. Unlike the years leading up to the financial crisis of 2008, these new increases in aggregate consumption are actually quite sustainable since they’re not being fueled by the loosening of the credit markets. Basically, this isn’t a round of voodoo economics propping up the economy – this is the real thing. I’ll get concerned when banks start providing mortgages to families on food stamps again, but until then it seems that the growth of the consumer economy is legitimate.
It’s impossible to know where the market is headed in the short term due to the potency of financial headlines, but fundamentals do not support the case for a prolonged bear market in the US indices. In addition, the overextended rally of the greenback should provide more backing for appreciation of risk assets as people begin to question the legitimacy of the single currency. Lastly, there’s the looming possibility of fed intervention, which grows more likely with every uptick of US dollar funds (NYSEARCA:UUP). If, or when, the Fed decides to act we should see Treasury yields climb substantially as the floodgates open and everyone returns to other currencies and risk assets. This would be highly bullish for the fund TBT, which is one of the best ways to play rising interest rates.
Dips in the stock market should be bought. While dollar strength might continue to the mandatory correlations that the market is using these days, it doesn’t make sense to chase the deflation hype much longer. It’s going to reverse in a big way at some point, and you don’t want to be caught on the wrong side of that trade. The stock market will, at some point, enjoy a dropping dollar and a renewed focus on the fundamentals. Don’t miss the upside. Here are a few fundamentally strong companies that you can consider adding to upon additional drops.
IBM (NYSE:IBM) and Oracle (NYSE:ORCL) - By fundamentals, these are great plays on the IT industry. As you might know, the Oracle of Omaha has been accumulating large amounts of IBM. This is part of the reason why I favor Oracle, which has been performing a bit better in IT software (where the real money is). Still, Oracle does have the problem of relatively high European exposure that might sour your mood. Both companies have had their eyes set on emerging markets though.
Coca Cola (NYSE:KO) and Pepsico (NYSE:PEP) - As far as inelastic demand goes, these companies provide some of the best. In addition, P/E multiples are a bit better than other food industry giants like Kraft (KFT) and Kellogg (NYSE:K) right now. Growth in BRIC nations has been solid too, which really seals the deal. I cannot possibly foresee a financial catastrophe in Europe big enough to cause people to cease consumption of FritoLay products, or Minute Maid orange juice. Since the downside is so limited, I can't find much of an argument against these stocks anymore other than their boring price action.
Ford (NYSE:F) and General Motors (NYSE:GM) - These are certainly more risky bets than the others listed thus far due to the shaky environment regarding big-ticket purchases in the United States and abroad. In addition, these companies have been suffering from operating losses in Europe which are bound to get a bit worse, but BRIC growth has been substantial. For instance, GM just broke a new sales record in China despite fears of a massive slowdown in its growth. Ford has been doing extremely well in the United States despite high unemployment and terrible consumer sentiment.
There are obviously many more companies that could be listed here, but the point is already conveyed clearly enough – stocks are attractive right now. You can look at technical analysis all day and come up with 50 different conclusions on the short term direction of the market, but what matters in the long run is the fundamental value of the companies you’re buying. If we get an overall meaningless eurozone headline that causes a 5% drop in the S&P 500, it’s a 5% discount on your stock purchase. Remember, the world is not going to end.
"Look at market fluctuations as your friend rather than your enemy; profit from folly rather than participate in it."-Warren Buffett
Disclosure: I am long KO.