François Trahan — Portfolio Strategy & Quantitative Analysis
Below is our Portfolio Strategy & Quantitative Analysis library of research listed in reverse chronological order. Please use the search box to look for research on a specific company or topic, or use the Calendar, Archives, or Sector links at left to browse for research from a specific time period or sector. If you are a Wolfe Trahan client and can not access any of the links in our library, please contact ITSupport@WolfeTrahan.com to request our PDF decryption plug-in.Conference Call: “The Slow And Methodical March Towards A Double-Dip In 2011″ – Wed, Sept 8, 10:30AM ET
A Discussion On What Lies Next For Financial Markets
A 45–minute presentation from François covering:
Be Wary Of Sell-Side Forecasts, Economists’ Projections And Company Guidance!
Addressing the misplaced optimism of sell-side research providers.
How deleveraging and deflation has led to a breakdown in economic models.
A paradigm shift in the consumer’s attitude towards debt and what it means for growth.
LEIs Don’t LIE – What To Expect If Leading Indicators Breach Negative Territory
Anticipatory series of economic prospects continue to point to a downward trend in LEIs.
Positioning for outperformance in the next stage of the business cycle.
Wall Street’s love affair with this year’s worst performing sector – Technology.
What Could Alter Our View And What Options Are Left For Policy Makers
Staring at a slowdown with zero-bound policy rates … Is the U.S. the next Japan?
Gauging the timing and effectiveness of QE2, QE3 and beyond.
Can we count on rate cuts abroad or lower inflation to help re-stimulate the U.S. economy?
Analyst Estimates: What Investors Need To Know
An inflection point in leading economic indicators changes the dynamics of investing for all. In our Portfolio Strategy work, we have written (to the point of exhaustion) that the defining moment of 2010 would occur when LEIs peak – whether you are an asset allocator or a bottoms-up stock picker. We have already seen how things have changed with regards to asset class performance (e.g., stocks vs. bonds), style preference (e.g., value vs. growth), sector rotation (e.g., hyper-cyclicals vs. counter-cyclicals) and, even in the quant world with factor performance (e.g., beta vs. profitability). This morning we will get the August ISM Manufacturing report, one of the most important data points of the month. We expect growth prospects will continue to recede (as they have in most countries). Until there is a case for a sustained improvement in leading indicators, a preference for stability over cyclicality is likely to offer a good risk/reward tradeoff for investors.
In today’s report, we focus our efforts on earnings surprise, and its efficacy in producing excess returns across the business cycle. What we have found is that positive earnings surprise as a factor on its own is a decent alpha generator. However, when modeled around the business cycle, we see that its usefulness dries up after leading indicators peak. Investors that have made money in the past year by incorporating an earnings surprise factor into their screening process may want to reconsider its weighting when 3rd quarter earnings season rolls around. This is because the next earnings season will be the first one that investors see in a “post-LEI peak” environment. This typically leads to fewer companies beating analyst estimates and a more muted excess performance when doing so. One explanation for this is that guidance often diverges from earnings trends following a peak in LEIs as guidance is forward-looking and earnings are backward-looking. While LEIs are rising, we generally see both EPS and guidance rise in concert – thus an “earnings surprise” often coincides with a “guidance beat” as well. However, following a peak in LEIs, investors are less likely to see this, as the rise of “earnings surprise” tied with “guidance misses” increases. We expect third quarter earnings season to be less rosy than the past two. This suggests that investors ditch the earnings surprise models and focus more on the forward-looking data.
The Hunt For Growth Is About To Become More Difficult
Is it us or did Chairman Bernanke finally admit that the tools left in his arsenal are limited and that they will need to be used in conjunction with other policies (i.e. fiscal)? As we see it, this is the first acknowledgement by a senior Fed official that the backdrop and effectiveness of their policy tools are a little different than in recent decades. It seems they are beginning to recognize that deleveraging is the kryptonite of monetary policy. This would have been so simple ten years ago. Greenspan would have slashed rates and the markets would likely be off to new highs as consumers leveraged themselves yet again. We suppose the first step here is acknowledging there is a problem and the Fed just crossed it last week … about four months after the markets did.
If the decline in leading indicators holds, and GDP slows from here, then there will be less and less of an appetite for equities and probably more and more for bonds. While the 10-year yield is very low by “historical standards”, there are not a whole lot of comparable episodes of deflation or deleveraging, so in our minds there is still downside to bond yields … even from 2.60%. While the Fed now “gets it”, the chart above shows that most of the sell-side still does not. Analysts have just begun to revise long-term expectations for stocks (some at least) lower, but given how much P/Es have fallen, we should expect to see their expectations melt over the next few quarters. A more difficult Q3 earnings season could be the catalyst for a significant downdraft in analysts’ earnings expectations.
Today’s headline article in the Money and Investing sector of the Wall Street Journal attempts to explain why P/Es have fallen. We see three simple reasons: 1) leading indicators are declining; 2) deflation is near; and 3) economic growth is likely to be below trend for several years. Keep a close eye on this Wednesday’s August ISM release as it is likely to be the biggest market mover this week. We believe it is more important than Friday’s payroll figures as the ISM is forward-looking while jobs data is backward-looking. Another slip in the ISM would likely weigh on equities again … something most of our tools are forecasting. Stay tuned.
Is There Hope For Financials As LEIs Continue to Decelerate?
Since the peak in leading indicators in April, the Financial sector has been the biggest underperformer. Truth be told, the dynamics of the Financial sector have evolved and the increasing weight of cyclical industries within the sector has made it subject to changes in economic prospects. One of the primary drivers behind our underweight in Financials has been this high correlation to leading indicators and our belief that we are only in the early innings of a deceleration in economic prospects. Also, our analysis suggests that the influence of macro on the performance of Financial stocks remains just off an all time high (page 2). With our outlook for 2010 favoring stability over cyclicality, we remain cautious on the sector and maintain our underweight on Financials as a whole.
As economic prospects have dimmed, so has the sell-side’s bullishness for Financial sector earnings. Overall sell-side price expectations are still exuberant for the sector as a whole, but the acceleration in upward EPS revisions has significantly pulled in. This is not surprising given the sector’s poor performance of late. While we remain cautious on the group and maintain our underperform rating, sell-side targets for the sector still have a 12-month expected return target of 35%.
What is troubling to us about the future expectations for the Financials sector is that the sector typically does best in an environment where leading indicators are accelerating and we are just past a peak in LEIs. Many still question whether this is a prolonged slowdown or just a temporary blip, but our work on anticipatory indicators of LEIs would argue for a continued decline for several more quarters. However, not all is lost for the Financials sector, as some of the industries which we highlight in today’s report actually offer defensive safe havens for investors.
History Repeats … Textbook Rotation To Stability Continues
Our initiation piece back in March called for a flat to slightly down market. Indeed, the S&P 500 was trading around 1145 on the day of our conference call (March 10, 2010) and we put forth a year end price target range for the S&P 500 of 1,000 to 1,100. While it does not exactly sound like a controversial call today, the pushback at the time was tremendous. The premise behind this thesis was that leading indicators of the economy would stop rising and begin to decelerate BUT remain in positive territory. Truth be told, we need to re-assess this assumption since there is now evidence that LEIs might indeed be calling for a contraction in growth (see Philly Fed Index released last week). This is typically consistent with a bear market in stocks, not a flat market. Are we too optimistic? Possibly.
The average annualized performance of the S&P 500 past a peak in leading indicators is about 1%. In that context, it makes sense to expect equity returns to flatline past a peak in LEIs. The Philly Fed Index, considered to be one of the most reliable LEIs after the ISM, is now in negative territory. If this is not a fluke, then it will be a game changer for our market outlook as the S&P 500 likely has more downside than our current expectations. Note that we always thought LEIs would eventually go negative, just not in 2010. The Richmond and Dallas Fed indices are up next for release and should shed light on this.
What is troublesome about the Philly Fed already being this weak is that our work on anticipatory measures of LEIs argue for a continued decline for several quarters still. This is extremely problematic if we are already in contraction territory. Regardless, the financial markets are behaving in a fairly textbook manner at this point and we see no reason why this would stop. We continue to prefer Treasuries to equities and, within the stock market, advise clients to emphasize the boring (and most rewarding in recent months) counter-cyclical sectors like Staples, Utilities, etc.
Operating Leverage: Is It A Risk Or A Reward?
The current expansion has been slower to recover than in past recessions, largely due to a contraction in private-sector credit. Deleveraging has made, and will likely continue to make, the path of recovery unlike any that we have seen over the past 50+ years. There has also been a clear behavioral change in the attitudes towards leverage with regards to consumers – less is better today. While most definitions of leverage now have a negative connotation attached to them today, operating leverage is not one of those. Corporate America’s earnings have been quite resilient during this recovery, largely due to aggressive cost-savings initiatives. While top-line has grown moderately for most companies, earnings-growth has recovered with a bang – thanks to a 20-year high in operating leverage (the ability of a company to translate revenue growth into growth in operating income).
The good news is that corporate earnings have surprised to the upside. The risk, however, is that the current rate of operating leverage is likely unsustainable. With that in mind, we are not convinced that the sell-side agrees with that statement as earnings for 2011 and 2012 are expected to be $95.16 and $108.63. These levels imply growth rates in earnings of 17% and 14% respectively. If our base case scenario of slower growth in 2011 (~1% GDP growth) comes to pass, companies would likely have to return to peak operating leverage levels to get anywhere near those earnings estimates.
Most companies with strong operating leverage outperformed in 2009 and early 2010 as earnings growth surprised on the upside. However, looking ahead, we see high operating leverage as a factor that is likely to underperform alongside other higher-risk factors. According to Aswath Damodaran’s working paper entitled, “Estimating Risk Factors”, operating leverage is a major determinant of a company’s beta. In a world where LEIs are decelerating, we know we want to steer clear of higher risk factors such as beta as they often lag the market. Avoiding high operating leverage is just another chapter in our 2010 story of stability over cyclicality.
Markets (And The Economy) In Stimulus Withdrawal
Over the past few months the effects of stimulus have tapered off leaving financial markets in withdrawal. As the veil of stimulus has been pulled back, we’re seeing an economy that is highly polarized today with regards to the recovery. What is clear is that big business has enjoyed more of the benefits of policy stimulus than small business. We know that we are in unchartered territory today and that trying to compare the current recovery with past recoveries won’t give us many answers. What is different today is that we have an economic recession that is occurring at the same time as a credit recession. We don’t have examples over the past 60 years to point to as a means of comparison. Therefore, to expect this recovery to play out similar to ones of the 80s and 90s would be ignoring the impact of credit on the U.S. economy. A new road ahead requires new tools, new thinking.
Our view for a sub-par year for equities rests with leading economic indicators decelerating and slower growth expectations for 2011. A peak in LEIs hasn’t always meant a bear market. In fact, returns on average have been slightly positive (~1-2%). That said, some years when LEIs peak, markets fell by 15-20% and some years the market rose by 15-20%. Figuring out where equities will land in 2010 requires looking at all the tangential economic evidence to gauge the risk/reward at this point.
With the strongest part of the recovery likely behind us, the question today is how much will we slow (i.e., a double-dip versus a soft landing)? Interestingly, this is really a discussion that those who have actually recovered are having. In small business land, the question is how long before we see a recovery. With much of the U.S. economy well below the recovery threshold, the question really is will the strong segments of the economy pull up the weak, or will the weak pull down the strong? Given the track record of performance post stimulus (think: home runs of “stimulus” users in the MLB), we are more fearful of the latter scenario.
Why Tech Has Disappointed In 2010 And Will Continue To Do So
The underperformance of the Technology sector year-to-date is likely at the top of many investors’ lists of disappointments in 2010. Without a doubt, Technology was the high-flying favorite among investors by the end of 2009 as the sector gained 60%, outpacing the S&P 500 by 37%. Of all our recommendations in 2010, our underweight positioning on hyper-cyclical groups, such as the Technology sector, garnered the most pushback. Our biggest issue with the Tech sector is fairly simple – it remains highly cyclical. The relative performance of most Tech stocks remains highly correlated to leading indicators of the economy and LEIs have only just begun to decelerate. Moreover, our analysis suggests that the influence of macro on Tech stocks’ performance has never been higher (see page 2). This means that even the best Tech story out there is still at the mercy of the business cycle. With that, we continue to recommend investors avoid cyclicality in their portfolios across and within all asset classes, sector and industries. Stability over cyclicality continues to be our top call for 2010.
While the second quarter’s earnings season was another strong one, guidance for future quarters has been mixed. With Cisco’s top-line expectations disappointment last night (down ~7% in premarket), Tech is likely to start the day as the worst performing sector in 2010. Interestingly, Cisco’s earnings conference call contained the words “unusual” or “uncertain” a total of 19 times. Moreover, there were several references to a business environment containing “mixed signals.” This isn’t exactly a vote of confidence from what is considered to be one of the Tech bellwethers, but kudos to management for being forthright in their outlook. The environment for Tech companies is likely to remain uncertain and potentially weaken further if leading economic indicators continue to decelerate (our base case). The business cycle is now a major macro headwind for Tech shares, one that is likely too powerful for cheap valuations or good growth stories to support. On that note, it’s the mega-cap tech names (at the start of 2010) that have performed the weakest this year – the ones that appeared the cheapest and had the most exposure to global growth.
The Impact Of The Business Cycle On The Investment Process: Part III
If you share our belief that employment is more integral to the current recovery than at any time in the recent past, you’d probably agree that it was a disappointing week. Thursday’s report on initial unemployment claims was frustrating, and the 4-week moving average continues to remain stubbornly high. Friday’s payrolls report was underwhelming and the revisions to the prior month even more worrisome. We always say that the monthly jobs number has to be taken with a grain of salt as history has shown the average revision is 50%. That means the July employment number could safely be as high as +100k or as low as +35k when it is revised next month. The area of the payrolls report that we believe is being overlooked is the 100k state and local jobs that have been lost over the past three months – the largest drop since 1982.
Just like an increase in leverage helped to propel every economic recovery since the early 1980s, the leverage unwinding that is taking place today is doing the opposite. Deleveraging is now taking place in ~90% of the economy. With the exception of the Federal government (~10 % of GDP), consumers, state and local governments and corporations are all deleveraging to various degrees today. This many areas of the economy deleveraging is likely too much at once to continue carrying this recovery.
With the Federal stimulus set to slow in FY2011, and further increases in government debt hard to come by, which group will take one for the team and start spending again? Many say that corporations’ cash levels put them in the best position to do so, but many fail to consider just how much of that cash is held overseas and will never see U.S. soil. For consumers, a trend towards less debt is likely a behavioral change that will last for some time to come. As the cover chart illustrates, more consumers are refinancing to shorter-duration mortgages. This change in the attitude towards debt reduces the potential for increased consumption in the future. No pain (in the short-term), no gain (in the long-term).
Maintaining A Forward-Looking Approach To Markets & The Economy
Investors’ focus remains heavily anchored to July’s employment report set to come out Friday morning at 8am. As we have noted on several occasions, the U.S. economy is now more dependent than normal on employment since credit growth has been more or less non-existent in the recovery. Since personal consumption remains the major driver of U.S. GDP, employment growth is the key to sustainable growth. Truth be told, payrolls have been lackluster in the recovery to date. Once you strip out the impact of census workers, then the U.S. economy has added about 50,000 jobs a months in the past quarter. In the context of the largest fiscal stimulus bill in decades, official rates down to zero and quantitative easing in 2009, the job recovery thus far is really unimpressive.
Maybe this is the month that the tide will turn and we will print a big number. That’s what some folks are saying. Those who hold this belief point to the ISM Employment Index which remains elevated. That’s good news, at least for the near-term. The not-so-good news is that the leading components of the ISM release like new orders argue that employment will start to soften shortly. This is consistent with our work on series that are anticipatory of leading indicators as well.
The other big unknown when it comes to employment is the impact that state and local government layoffs will have on the overall picture. This is something that is not being captured by conventional leading indicators of employment. The vote by the Senate yesterday to extend some help to states to save teaching jobs might help, but the reality is that austerity will weigh heavily on all other government jobs as the aid from the Federal stimulus bill begins to fade next year. We will continue to monitor leading indicators of employment closely. They are the most important ones at this juncture. No jobs = double-dip. It is not our default scenario but let us be honest, it’s a real possibility.
