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.The Wolfe Trahan LEI Rises In The Week Ending 2/03
The level of the WTLEI rose last week alongside a rally in global equity markets and strong economic data. January was a very strong month for LEIs with nine PMIs showing improvement and only two moving lower. Both of the national surveys, the ISM Manufacturing and ISM Non-Manufacturing indices continued their upward trend. This week will be a quiet one and we will not receive the first February LEI report until next Wednesday (Feb 15th). Stay tuned!
The three components of the WTLEI exhibited strength across the board last week. The economic component boosted the index the most as the policy outlook, labor market, and credit conditions improved considerably. The housing component was the one segment of the WTLEI that dragged on the index last week. Strength in the market and sentiment components added to the improvement in the WTLEI last week.
A Goldilocks Economy In The “New Normal” … Take 2
It’s time for honesty. It is very hard to be bullish on the economy and the markets with all the structural headwinds facing the world’s economy. That said, we are more convinced than ever that it is the right call today. Indeed, if there is one lesson to be garnered from Q4 ’11 it is that the cyclical outlook is all that matters to equities in the near-term … structural issues are just not relevant in that timeframe. The cycle is clearly heating up in the U.S. and abroad and equities are responding accordingly. To be truthful, we are not even sure what the bear camp is thinking anymore but it must be pretty lonely.
We’ve been making comparisons to the Japanese experience for some time now. It is generally not viewed as a popular topic with clients. Here’s one bright light in that thesis. The Nikkei has had four rallies of more than 50% in the past 20 years and all of those occurred in the wake of a decline in inflation. This is exactly what the U.S. is experiencing today and the market is behaving similarly. Like Japan, a drop in inflation in the U.S. is a form of stimulus and clearly the backdrop is reflecting that.
So our thesis that “inflation is the new Fed Funds rate” looks more plausible now that the economy has rebounded. How does one argue with this data? We are clearly as bullish as it gets and even we are surprised by the strength in the employment figures. Take a look at leading indicators of employment and you simply cannot believe a recession is in the offing. As the chart above highlights, the average workweek is now sitting at its highest readings in over a decade! Surely, one can explain this as a one-off … just like you can explain claims coming down so much as an aberration. We hate to say but, “it’s the economy, stupid”. This won’t last forever but it is Goldilocks as we begin 2012. Enjoy!
Junk Rally Or Return To Cyclicality?
Stocks are up 21% since the October bottom in the market. LEIs have significantly improved and look set to maintain their positive trajectory. All is well in the world … right?!? In the minds of many investors, issues such as the European crisis, housing, and employment continue to take credence from the improvement in the stock market. As such, the lack of faith in the return of cyclicality has led many to dust off the “junk”-rally branding. We have recently begun to hear in the media and from investors that “junk” is outperforming and “quality” is underperforming. Today, we take a look at whether or not this is true (it’s not!) and how investors can properly position their portfolios for a rise in leading indicators.
In our minds, the run-up in equities over the past several months isn’t so much of a “junk” rally as it is a return to cyclicality. Understanding why investors and the media label such rallies as “junk” is a hard question to answer. It may be that we are victims of our environment and, outside of the market strength during QE2, we have been in a stagnant market for the better part of two years. Roll the clock back even more and you have the financial crisis where defensive positioning was the only way to keep your head above water. Are we just being slow to adapt?
In today’s report we delve into answering some of these questions and respond to the rebuttals surrounding the recovery in equities. Beyond just answering a few questions, we look at how this rally and the return to cyclically have played out on the sector and factor level. As any reader of our work knows, we believe the turn in the market and the associated shifts in leadership all come down to changes in the business cycle and the path of economic prospects (LEIs).
A Goldilocks Economy In The “New Normal”
The pushback has eased. We wouldn’t say that the crowd embraces our view just yet, but it’s clear that the folks arguing vehemently in the first few weeks of the year have quieted down in the past week or so. We are, after all, approaching the four-month anniversary of the rally and recovery in LEIs and this is the amount of time it took last year for investors to change their tunes on the outlook. Since the business remains largely driven by bottom-up investors, it takes a change in the language/attitudes of companies for the Street to truly embrace a view … maybe earnings season is beginning to do that.
We have many clients that are uncomfortable with the rise in oil prices taking place alongside the rally in equities. This is similar to what happened in 2009 and again in late 2010. To be sure, this is actually similar to what used to happen with the Fed Funds Rate. Indeed, for the past decade, stocks rose alongside official rates. Think of oil as a new form of tightening and there is nothing odd about its current behavior.
The good news on the oil front is that natural gas, and gasoline to a lesser extent, have not kept up with the rise in oil. This suggests to us that the economic tipping point for oil is likely far higher than last year’s $128/barrel. Moreover, the fact that the economy is now creating jobs also argues for a higher oil threshold than in the past. All that said, we track the relationship between oil closely as the charts above show. If we were to see a rise in oil and a loss of momentum in the market we would probably have to change our bullish tune. The good news for now is that the relationship seems very strong. Enjoy while it lasts.
The Wolfe Trahan LEI Rises In The Week Ending 1/27
The level of the WTLEI rose slightly in a relatively mild week for financial markets. Thus far for the month of January, the WTLEI has risen nearly 5.5%, the largest one-month rise since early 2010. All four of the reported leading indicators have ticked up and have brought some reassuring news regarding employment and manufacturing. This week will bring 7 more leading indicator reports for January, including the national ISM Manufacturing and Services reports. Stay tuned!
The three components of the WTLEI were mixed last week with the market and sentiment components slightly higher and the economic component slightly lower. Most of the weakness in the economic component was driven by the policy outlook while strength in the other components was broad-based.
The Wolfe Trahan LEI Rises In The Week Ending 1/20
The level of the WTLEI rose last week alongside strong economic data and strength in equity markets. The first LEI reports of 2012 were encouraging with both the Philly Fed and The Empire Manufacturing Index showing improvement. Please note that both of these indices posted annual seasonal revisions along with their January reports. The Richmond Fed Index will be released tomorrow at 10:00 AM ET and the Kansas City Fed report will be released on Thursday. Stay tuned!
Each component of the WTLEI rose last week on broad-based strength. While the Sentiment component showed improvement, the bulk of last week’s strength came from the Market and Economic components driven higher by global cyclical equities and housing activity respectively.
The State of the Union For Portfolio Strategy
The thesis we have pursued over the past year is fairly simple: inflation is the new Fed Funds rate. What we mean here is that inflation now plays the role that the Fed Funds used to play as recently as five years ago. In the old days, if the Fed was raising rates it was fairly clear that the economy would lose some steam down the road and vice versa. Nowadays, it is inflation that plays this important role in the U.S. economy. To recap, inflation rose in the wake of QE2 and the economy subsequently slowed … inflation then ebbed lower and the economic data points have improved significantly.
A number of clients have pointed out to us that this is not a sustainable dynamic as the recent rise in oil will surely bring a halt to consumption. This is true …. in due time. That said, it is very difficult to know what level of oil will manage to slow consumption meaningfully much like it was difficult to say in 2004 just how much the Fed would have to raise the Fed Funds rate to slow the economy. Some argued it would be 2%, others 3% …. it ended up being 5.5% three years later. The “economic tipping point” price of oil is a moving target and with the budding recovery in employment figures of late it is probably higher than most believe.
Another factor extending the current dynamic is what’s taking place in other commodities, namely natural gas. The price of natural gas has continued to decline in recent months despite a recovery in oil. This is great news for the markets as it is the equivalent to a tax cut on U.S. consumers and companies. The chart above highlights the important relationship that natural gas holds in the economic equation. It is not a perfect correlation but it is clear enough to see that it is substantial. It’s been a robust start to the year and the drop in natural gas suggests leading indicators will probably continue to rise in the quarters ahead … and likely faster than even the bulls anticipated. As always, time will tell.
Improving Global LEIs Strengthens Bull Case For Materials Sector
In the wake of the global financial crisis, we’ve entered a period of economic uncertainty where the dynamics of forecasting economic trends have changed (e.g., “inflation is the new Fed Funds rate”). Cycles have been much faster and more volatile … this has frustrated many on and off Wall Street. What is shocking is how off-base the economic-forecasting community (e.g., Fed, IMF, CBO) has been. Stocks in the Materials sector are highly leveraged to global growth prospects, so naturally one would think that the World Bank’s recent downgrade of world economic activity in 2012 would bode poorly for the sector. But as the cover chart illustrates, changes to global growth expectations from major economic-forecasting organizations such as the World Bank and IMF have been great opportunities to take a contrarian position, especially within cyclical sectors such as Materials.
The World Bank’s recent downgrade of global growth is the equivalent to the NBER announcing a recession – its old news, and markets are likely already looking past it. Last year’s performance in Europe (STOXX 50 down 17%) told us that GDP growth was going to be sub-par in 2012. What’s more important is what the World Bank may be saying 6 months from now – the data points that help forecast this are leading economic indicators – which are improving globally at an increasing rate. Today provides a great backdrop for us to reiterate our overweight in the Materials sector (and everything else cyclical). This report goes into further detail on why we believe this sector’s outperformance will continue and which industries within Materials are poised to lead the sector higher.
What If … (Part 2)
Over the past few months we’ve tried to explain the bull-case for owning stocks amidst tremendous pushback from the majority of our clients. What we’ve asked our clients to ask of themselves is where the market would be today if they had been on a deserted island only reading the news headlines. Most responded with a market that has corrected in the vicinity of negative 15 to 20 percent. Of course, since the October lows, the German DAX is up over 24%. It is clear to us why markets have recovered – it is because leading indicators of economic growth are rising and there is stimulus in the pipeline. In mid-November of 2011 we published “What If …” and posed the question, “what if the European data began to improve” using the same chart of the ZEW and prices paid below. Two months and two “unexpected” upticks in the ZEW index later we question … will the improvement in Europe continue? We think it will.
A typical client meeting of ours usually gets caught up in discussing the structural risks presented by the Eurozone and when we finally get past those issues, the conversation tends to move immediately to one of China risks. With regards to fat-tailed risks, China is the second-most likely candidate causing investors’ agita in 2012. In this second “What If” report, we suggest investors ask themselves what if the economic and market data in China begin to improve like it has in the United States and in Europe. We offer a handful of charts on pages four and five that are telling us that we are at a major inflection point in China today. Futures are up this morning largely on the better than expected economic data reported in China last night. Our forward-looking indicators for the emerging world suggest that this is the start of a new trend of better economic and market activity in that region of the world. As always, time will tell.
The Wolfe Trahan LEI Rises In The Week Ending 1/13
The level of the WTLEI rose slightly last week alongside a slight improvement in equity markets and commodities. The final tally for December LEIs weighed in at 8 up and 5 down. This week will bring the first LEI releases of 2012 with the Empire Fed index today at 8:30 ET and the Philly Fed index Thursday at 10:00 ET. Stay tuned!
Each component of the WTLEI rose only slightly as most data series remained relatively flat last week amidst muted volatility. However, housing proved to outshine other data as mortgage applications picked up. The Market component was supported by a rise in commodities and global cyclical equities while the Sentiment subcomponents were mixed.
