Well, given the equity market's excellent performance during the last five months, we thought we should provide some thoughts regarding our past and future strategies. We'll first review performance of our recommendations and then we'll provide some thoughts regarding oil and the state of the economy. We will also touch on why we think it may be time to move towards a slightly less risky strategy.
S&P 500 went below the 1,120 level which allowed us to implement our more risk-on and aggressive strategy, as we mentioned in late Sept. '11. It actually closed at its year low of 1,099.23 on 10/3/11. The index has increased approx. 22% from the 1,120 level. XLY, consumer cyclical ETF, increased by nearly 29%.
GLD has increased by only 4% since our last post, but then again we all know that it has outperformed the equity market over the long-term.
Looking ahead, S&P 500 is at 13.7x and 12.6x CY '12 and CY '13 EPS estimates, respectively. It may be surprising, but we think the '12 multiple is more attractive as it assumes a 15% EPS growth, which translates to a mere 0.9 one-year PEG. A PEG of 1.0 would mean that there is another 10% upside to the S&P 500 for this year. The 2013 estimates represent a PEG of 1.5. Excluding the 'Great Recession', S&P 500 has been trading at average one-year PEG of only 0.9 during the last 23 years. In addition, recent increase in oil prices could impact not only economic growth but also company margins which may result in lower than expected EPS.
The economy appears to have stabilized a bit, given the latest employment, consumer confidence and manufacturing data.
However, we note that the recovery remains very moderate at its best. Companies have basically cut to the bone and can no longer reduce HR. In addition, a big chunk of the hiring has been of temps.
In terms of economic growth, consensus for '12 GDP growth is a mere 2% followed by 2.2% in '13. We note that these estimates may be negatively impacted by recent rise in oil prices.
The housing market remains at the bottom, although existing and new home sales have been improving. Such improvement in sales and decline in inventories have been driven by short sales, foreclosures and bulk buying by institutions. Given lack of enough wage growth and continuing deleveraging by consumers, it may be tough to see a strong rebound this year.
We must point out that even though the latest economic data has been positive, it could have a negative impact on the market as it may reduce the chances of implementation of the Fed's QE3. Without such 'insurance' provided by the Fed, overall risk associated with the equity market could increase.
In addition, the sovereign debt crisis in EU remains. Greece may have kicked the can down the road, but there will come a time when it will have to clean up its mess. The same can be said of the other PIIGS. And debt crisis is not the only thing EU has to worry about these days. Given the current economic downturn in that region, the US lawmakers have actually begun to put mainly Greece, Italy, Spain and Belgium in literally a choke hold. None of these countries can say no to the US oil embargo on Iran which will begin in July. Such embargo will not only increase oil prices (as we have already seen), but it will also negatively impact those countries' potential economic growth as they will have to spend millions on their refineries to handle oil coming from other providers, which by the way have not yet been determined.
And this takes us to our so-called oil analysis. Since the end of Q3 '11, WTI oil spot price has increased 35%. Front month futures crossed $110 last week. And as a result, gasoline prices are expected to hit record highs even before the big driving summer season begins.
Oil has risen due to some economic stability in the US, some very modest growth, possibility of a QE3 by the Fed, and of course the war gibberish spewed out by Israel and the US, to which Iran has reacted with more gibberish. The last factor, the geopolitical one, we believe, is the biggest driver of higher oil prices.
How will higher oil prices impact economic growth? Given what we believe to be a quadratic relationship between oil prices (inflation adjusted) and real GDP, our analysis of historical data showed that oil prices likely impact GDP negatively if they reach levels above $105, which they have. Given the non-linear relationship between the two, we cannot say how much each $5 increase in oil price will impact GDP. We can say that at $110, GDP growth is likely impacted by approx. -12bps; at $115 by -30bps; and at $120 by nearly -50bps or -0.5%. Some believe WTI could go as high as $130 this year, potentially knocking off 1.0% from GDP growth, based on our analysis.
While President Obama, when speaking to AIPAC today, sounded as though he may not want to hit Iran, we must admit that history has proven over and over that it is not the President of the US that makes decisions regarding policies in the Middle East! And the President understands that the more talk there is, the higher oil prices will go which may hurt his chances of remaining in office. In addition, if Israel does strike Iran, given US' commitment to the state of Israel, it is very likely that the US will get involved one way or another. We will likely get more color on this, at least for the short term, tomorrow during Bibi's and Obama's press conference.
In our opinion, July is the key month. We don't think any military action will be taken between now and July. We think this is due to the US at least giving some EU countries (mainly Greece, Italy and Belgium) some time to adapt to the embargo which they are forced to ... force upon Iran. As we mentioned earlier, the oil embargo could be costly for those countries to abide by.
Chances of an attack on Iran, assuming nothing else changes, will likely increase after July. Some so-called "market indicators" indicate that there is nearly a 40% chance that either the US or Israel or both will execute an overt air strike on Iran before the end of this year. Although this figure is below 50%, it is considerably higher than the 23% and 30% representing possible strike before end of June and Sept., respectively.
Given possible chances of attacks on Iran and its negative impact on the economy and the equity market, a couple of simple strategies might help reduce such potential impact. If there is an attack, oil prices will jump further. It's not only Iranian oil but also oil from Saudi Arabia and Kuwait that may be at risk given the possibility that Iran can create havoc at its Strait of Hormuz. If there is no attack, then the premium currently in oil prices will likely be reduced. Given all of this, a less costly strangle position on USO could help. We recommend the out-of-the-money positions for calls and puts that expire after July, or in Oct. The same reasoning could be applied to holding a strangle position on VIX.
In terms of equity positions, the market is getting closer and closer to being fairly valued, assuming no unusual events take place. Given this, we would probably begin moving some of our positions into safer sectors such as staples and utilities, both of which may benefit from possible upturn in oil prices and/or an economic slowdown.