The U.S. and World stock markets remain in bull-mode, which was my expectation based on my April 2009 letter. This move up was triggered by data that revealed things were not as bad as the consensus expected which caught the majority by surprise since the sentiment of investors was intensely negative in March. Stock markets are rebounding on par with previous waterfall declines and the emergence of the economy from recession to growth. The lows in March will likely be the lows for decades.
Based upon numerous studies of past waterfall market declines I would expect the stock markets to churn higher as evidence continues to mount confirming the end of the recession which in turn will give investors more confidence. In a complete reversal of last Fall’s sentiment of “Get me out I can’t take it anymore!” we are now hearing “Get me in, I can’t take it anymore!”
Recent data indicates that the U.S. economy is now out of recession and that July will mark the first month of growth. Looking back to previous periods of recession segueing to growth, stock market declines are usually shallow and short of single digits which don’t allow investors an easy entrance. In addition, as Summer turns to Fall “performance anxiety” will start to be a major driver forcing investors and professionals to commit to risk as it will be clear that the Bearish majority opinion favored early this year is clearly out of sync at present. There may a “melt-up” as the anxiety to perform becomes intolerable.
I would caution investors against allowing the fear and risk aversion that was rampant in the past year from coloring their view going forward. The portfolio that was well positioned last year for the crisis will be poorly positioned to handle the economic recovery now forming.
Its extraordinary to watch the talking heads on CNBC wax wondrous about the stock market when the majority of them were cowering under their desks or outright bearish this Spring. Fear is dissipating and a return to risk taking continues as credit spreads shrink. Within the last week Goldman Sachs and Credit Suisse have upped their year-end targets for the S&P 500 to the vicinity of my own target of 1050-1100. While its good to have company, which in turn will instigate more buying pressure, my views on the market rally are no longer in the minority opinion so I must keep an eye out for a potential development that could break the bullish consensus.
The most perplexing question I face at the moment is whether the traditional seasonal market weakness from August to October will occur this year. In past transition years, noticeable market weakness within six months of a transition from recession to expansion is rare. In 2003, which was our last transition year there was no noticeable weakness until 2004, we may see the same lack of pullbacks this time. Typically in post waterfall declines we could expect this current rally to live for at least another six months to early 2010. In contrast, research on market cycles from Ned Davis, which I showed in chart form in April predict a market top in August, leading to weakness thru October followed by a strong rally thru December.
Based on past conference calls with clients there seems to be confusion at how we could be moving to a period of economic expansion with headlines so bleak. So, if you find yourself scratching your head at how we could be moving from recession to expansion I’d like to quote Anirvan Banerji of the Economic Cycle Research Institute:
“Indicators are typically judged by their freshness, not their foresight.”
Generally little context is ever provided to shed light on the data as to whether the data is peaking or not, as to whether a leading, coincident or trailing indicator. For example employment is a lagging data point and typically peaks after the economic trough. The lag time varies considerably from one month (1982) to 19 months (2003).
Stock Selection: Small versus Large: Performance data continues to suggest that our strategy of preference for Small Cap Growth stocks with modest valuations otherwise known as GARP (Growth At A Reasonable Price) has been spot-on. Small GARP stocks out-performance will likely be a long-term, multi-year trend. For example, the average length of Small Cap out-performance versus the S&P 500 since 1926 is 71 months and as of this month I estimate we’re only in month 14.
The effects of a newly expanding economy with increased desire for risk are having a profound impact on our domestic Small Cap Holdings. Our biggest winner of the year has been Global Cash Access LLC (GCA), which we were able to acquire initially at just under $4 a share and has reached $9 a share.
Domestic and Emerging Markets: In addition to our preference for Small Cap stocks, I have significantly increased our exposure to Small Cap Emerging Markets stocks. Emerging Markets have displayed superior relative strength to the U.S., Brazil and Chine in particular. While this performance is a reflection of increased confidence in their ability to manage the downturn, they are also not hindered by a depleted, over-leveraged consumer or anemic GDP growth. With these factors in mind I continue to believe the Emerging Markets have superior risk/reward over the next 2-3 years versus the U.S. markets. I am very concerned that the U.S. stock market may drift sideways for an extended period after our present rally. Diversification into Emerging Markets is a strategy to reduce our dependency upon the U.S. economy and stock market. In fact, one should consider that a significant percentage of our demand expansion in the U.S. is originating and being driven from Asia, specifically China.
The returns from our EM holdings have been beyond my expectations, our holdings in China have been spectacular. Our “Green” holdings in China Green Agriculture (CGA), RINO International (RINO) have exceeded 100%. We were fortunate enough to identify both CGA and RINO before they gained a listing on the NYSE or NASDAQ. Once they received approval to trade on our exchanges their appeal broadened due to the increased exposure to U.S. investors. Benign companies such as China Automotive (CAAS) and Chinacast Education have been outstanding as well and helped to lift accounts back into positive territory after a dismal 1st Quarter. These stocks are not without volatility and saw their valuations decimated in 2008 which created an amazing situation of highly profitable and growing companies priced at rock bottom valuations.
Bonds: As stated in previous client letters Treasury Bonds were due for a decline. Since December, at the height of the credit crisis the Ishares 10-20 year Treasury Bond ETF (symbol TLH) traded at $123 a share but by last month the shares were down to approximately $104 which highlights the risk of following massed emotions during the crisis. Insult to injury to those investors who panicked and sold off their stocks to buy Treasuries. On the other hand we took advantage of the declines in economically sensitive debt which were abandoned during the crisis. Yields on Corporate and Preferred Debt reached 14% to 17% during the late 1st Quarter and have since rebounded to 8% to 13% (yields decline as prices rise).
Treasuries are no longer as unattractive as they were six months ago as the bubble in Treasury prices has popped. If the economic rebound is as anemic as suspected, Treasuries could become a haven against economic weakness. Hence, recent debt purchases have been in high grade Treasuries or TIPS (inflation protected Treasuries).
Potential signs of the end of the rally: Rallies emerging from waterfall declines can exceed in breadth and duration beyond the most optimistic investors, I would not be surprised to see our current rally last through the end of the year without nary a pullback beyond a handful of percentage points. Sometimes the hardest position to take as a strategist is to do nothing….to let the rally run its course.
Premium valuation – If the market were to exceed 18x earnings of $60 a share or 1100 on the S&P 500.
Rising corporate bond interest rates – Since early November the gap between corporate and government bond yields has been shrinking, if this spread were to begin to widen once more it would be cause for concern.
Excessive investor exuberance – Markets do move on psychology and just as the March lows saw investor despondency, sentiment has been steadily improving (or getting worse depending on your point of view due to the inverse nature of psychology) and we must be on the alert for frothy behavior. We are getting close to excessive exuberance but not quite there yet.
2010: It’s my belief that the negative views of the Bears, which are being ignored at present, will manifest themselves in 2010. By no means am I predicting a crash or another bear market, “lackluster” might be a good word to describe the broad indices next year. By 2010 stock market valuations will no longer be cheap, inflation pressures could emerge, or anemic economic growth peters out with the lack of stimulus. By 2010 the economy will be forced to walk on its own legs without the support of massive economic stimulus. Fears of a Double Dip recession with accompanying national debt could emerge which would likely put pressure on stock prices, especially in the US. It would be unwise to assume that economic growth from here will be any more than lumpy, inconsistent and anemic.
Our present rally will continue to assume economic growth into 2010 and 2011. These assumptions could be set the stage for potential disappointment if they fall short. While it feels wonderful now to believe in the potential for growth, investors should keep a balanced view and err on the side conservatism until future market weakness and investor sentiment reaches the point to have factored in lower than average corporate earnings growth next year.
RMHI Blog: In an effort to provide clients with current information regarding market outlook, holdings, etc, I’ve created the RMHI Blog which you’ll be able to view at our new updated website at: www.greeninvestment.com/blog. Its my hope the Blog will bridge the information gap between quarterly letters and give clients a feel for what’s going in the financial universe.
Warmest Regards,
Brad Pappas
July 23, 2009
In our most recent quarterly letter we mentioned the subpar revenue growth for US based companies. This anemic revenue growth stood in stark contrast to many Emerging Market companies that have excellent top line growth.
One of our favorite purchases….the purchases that make you scratch your head as you just wonder how and why it became so cheap has been China Automotive Systes (CAAS).
CAAS just boosted revenue guidance to at least $195 million versus $163 million in 2008. Second quarter earnings came in at 21 cents versus the estimate of 12 cents which obviously means estimates for 2009 and probably 2010 are too low. The stock is now gapping higher to $9.45.
While we’ve pared off a small fraction of our shares into todays strength, the message to our clients has been that the gains to be made in Emerging Markets is substantial since many do not face the significant and non-traditional headwinds facing the US economy.
We’re not a buyer of CAAS at these levels but should the Chinese market pullback, possibly so.
RINO finally had some air taken out of its levitation yesterday, this is why we peel off shares into great strength from time to time. When stocks become beloved and traded by the Momentum crowd the slightest negative news can bring a torrent of selling as the Mo-Mo’s sell as blindly as they buy. The company missed its estimate (there was only a single analyst) by a couple of pennies but was otherwise a very solid quarter with substantial revenue growth. The stock is tempting under $14 which would be at just under 8x 2009 estimates.
Be careful out there.
There have been a few stories in the media over the weekend regarding how the slow rate of economic growth will force Central Bankers round the world to continue to provide easy monetary policy for the forseeable future.
Barrons interview with Michael Hartnett highlighted the positive aspects of slow growth and easy monetary policy this would allow low interest rates to remain for the foreseeable future and not represent a significant headwind to the stock market.
Reports from China’s Premier Wen Jiabao that China will maintain its current pro-growth monetary and economic policies for the near future.
While these policies will represent a tailwind for investors in the short term, they are fraught with hazard longer term. Keep in mind, this is how bubbles are formed. Its now common knowledge the easy policies in 2002/2003 contributed to the housing debacles of 08 and 09, the root lies in easy credit along with easy regulations.
My point is assuming a base earnings of $60 for the S&P 500 in 2009, if we achieve 1150 on the SPX the S&P 500 will be selling for 19 times 2009 earnings well best the historic median of 16 times earnings.
If we do enter the Double Dip Recession as Doug Kass fears, where will the Monetary stimulus come from to alleviate the dip?
Its all well and good that monetary policy remain easy, as I believe the economy is much too fragile without revenue growth and the political poison of increasing unemployment. But the easy pickens in the US markets will have been picked and risk high regardless of our monetary policies. This is in sharp contrast to years past but then we live in unusual circumstances these days.
Doing very little buying these days. Mostly just peeling off shares of China Green Ag and RINO Intl. as they have gone parabolic…..unlike the Red Sox which have gone anti-parabolic.
Keep cool out there.
Brad
Part of our performance this year is due to a handful of Chinese Bottle Rocket stocks Rino International RINO being the most spectacular. By no means would I suggest buying this stock now as it is being discovered by the momentum traders who can either propel it into the $20’s or pummel it next week upon the earnings release. Our research uncovered the company before it became U.S. listed while trading under $7 or 3x current year earnings.
RINO is part of the newly emerging Green companies that provides environmental remediation in China. The stock has tripled since our initial stake in the company but the PE/G remains at a very most .40.
Can this stock go higher, absolutely. The growth rate could support a much higher valuation, but one must consider the risks associated with China thus a discounted PE (relative to the U.S.) to the 2010 estimate of $2.14 is in order. The PE to tag the company with is open to debate 10x, 12x? The mo-mo traders can push this to the mid $20’s easily upon a good eps release next week. At that point, better to be a seller into strength.
Be careful out there.
I do plan on adding much more to this blog over the coming days and weeks but client reports and trading are taking the bulk of my time.
From my view, the move off the March lows is really not that surprising. Markets that refuse to come in with extreme overbought or oversold readings usually have more work to do in their primary direction. If you look at market history you’ll find similar rallies after such spectacular waterfall declines: 1938 and 1975 come to mind.
But what is the hardest trade to make in this kind of unrelenting market? In my opinion its to do nothing, to sit on your hands. Famed early 20th century trader Jesse Livermore once said “It was never my thinking that made the big money for me, it always was my sitting.” That, might be the hardest trade of all today.
Rocky Mountain Humane Investing Outlook: April 2009 (Posted July 2009)
“Markets do have a lovely tradition of overshooting themselves both in the upside and downside”: from the RMHI 1st quarter client letter.
Is there a more droll way to describe the emotions of early March? It would have been uncommonly rare to have seen the selloff in late February and early March evolve into a lasting period of price erosion without some sort of quick rebound, only the 1929-31 period showed a lower low after such a devastating waterfall selloff. The selloff in March created a sense of investor despondency and incoming phone calls only seen at major market bottoms. This depression stood in contrast to a string of data points suggesting emerging stability that I wrote of in January:
- “Declining New Lows: On October 11th when the SP500 first reached 850, the number of stocks making new lows exceeded 3000. On January 20th the SP 500 touched 804 and the number of new lows was 186. Despite the SP500 being actually lower than 10/11, the number of stocks making new lows is only a tiny fraction of previous sell-offs. This trend has been apparent since November when the index made what might be the ultimate low for this Bear Market of 740 yet the number of new lows was just 600.” At the March low there was only 855 stocks making new lows, despite the market being 22% below the October low. In addition, volume at the October low was 2.85 billion whereas the March low volume was just 1.56 billion, clearly a marked drop in selling intensity. All major market bottoms showed this behavior.
- “Crude oil prices: Stability in oil prices may mean we’re reaching stability.” Crude oil and other commodities are frequently a barometer of worldwide economic activity. The May futures contract for crude broke out of a downtrend in the third week of February and have rebounded from $40 to $54 a barrel. In addition, industrial use metal Copper broke its downtrend at $1.40 and has rallied to $1.80.
- “Baltic Dry Index: The Baltic Dry Index of shipping rates for container ships has leveled off after a precipitous decline. The Baltic Index is a very good forward indicator of worldwide economic activity. It reflects the prices paid to hire an oceangoing freighter to haul goods or raw materials. In recent years, China has been a driver in pricing with their economic expansion.” While the Baltic Dry index is not an ideal barometer of economic activity in this cycle (a probable glut in oversupply of available ships, causing cheap pricing), the lack of continued price erosion is clear.
- “A roadmap of composite (1929-2002) post-crash DJIA performance. Ned Davis Research has done a fascinating study of post crash declines in excess of 20%. Although the “crash” phase was not the actual end of the Bear Market, the declines were not exceeded either. Retests of the market lows were very common and generally occurred within 90 days of the waterfall selloff. In our case, October 11 would be the 0 date while November 20, 2008 remains the ultimate low of this Bear decline, which perfectly parallels the composite roadmap of this chart. Other points of merit: The waterfall selloff occurred on average of 130 days before the end of the recession, but the markets started to make progress approximately 70 days before the end of the Recession. Based on analyst estimates for the Standard and Poors 500, the approximate end of the recession could be in the 2nd or 3rd quarter of 2009, which coincidently matches Davis’s chart.” While the markets did go to new lows in March, they did not break and with blazing speed erased the March decline in two weeks. Furthermore, my reference to the parallels of 1974 and 1938 continue to look accurate, especially 1938.
Mark Twain said: “History doesn’t repeat itself; at best, it sometimes rhymes.”
Economies and equities have gone through boom and bust cycles many times over the past hundred odd
years. While the reasons for the boom or bust change with each cycle, the reaction of the market place
post-collapse, which is based largely on human psychology and economics reveals a pattern that continues
to rhyme with surprising frequency and accuracy. These patterns of market behavior are most accurate in
the transitional period between Bear and Bull cycles but lose their accuracy once the transition cycle is
over, whereby the markets are on their own and trade according to new incoming data.
In January, I brought this chart to your attention:
“We are in a moment “in-between” of gray twilight between dark and dawn”
In early March we found ourselves in a period of agonizing investor angst yet improving market internals and even more astonishing…….. early signs of economic stability and yes……….improvement. The U.S. Equity market staged a rally with breathtaking swiftness and rebounded from 650 to 830 on the SP500.
In January, Ned Davis Research published a chart that has been uncanny both in terms of market seasonality and behavior and is likely a good road map for 2009. This “road map” is meaningless unless the underlying economic data support the price movement. The March rally has been unique in that it was supported not by government acts but improving economic data, a contrast to the failed rally of November and December.
Ever since the market bottom in October there have been a series of false starts where rallies petered out in a matter of a few short weeks. These rallies were only technical in nature; there was no underlying fundamental reason to support them as the economy remained in freefall. Since the bottom in early March, there have been six 90% upside volume days, a clear difference than the tepid rally in November and most importantly the rally coincided with news from Citigroup, JP Morgan and Bank of America that January and February were profitable.
A cyclical Bull Market to last till late summer, in five steps:
Step One: The composite chart above details a brief “blast off” rally in the range of 18% starting in late
February. These rallies catch everyone by surprise, as they appear to come out of nowhere but do coincide
with bottoms in the economy and investor sentiment. Our rally appears to have peaked at 23% and started
in early March rather than late February.
Step Two: A period of consolidation for the market to digest the move. The market pulls back a bit but
doesn’t break lasting for 4-6 weeks. I believe we’re in this phase now.
Step Three: A 30% rally as investors see further evidence of the economic bottom with the prospects for
the recession ending and stability in housing. This move like Step One is a virtual race to get invested by
an underexposed hedge fund industry and others. In the past 10 recessions, the stock market has staged a
lasting and major bottom on average 4 months before the end of the recession, or mid Summer 2009.
Further argument for the end of the recession by summer will be the effects of the Presidents stimulus
package, which will start to resonate within the economy in the second quarter of 2009. Earnings estimates
by Standard and Poors validate this thesis as well with a quarterly earnings jump from the 1st Q to the 2nd
of $13.00 to $14.96.
Step Four: The pause that refreshes. The months of June-July bring a second gentle period of
consolidation as the gains are digested by trending sideways. Stock market rallies coming out of
recessions are generally always exceptional but they don’t move in a straight line.
Step Five: A midsummer and final rally in the range of another 25% to the normal stock market valuation
of (100 year average) 16 times 2010 earnings of $66 or approximately 1100 on the SP500 by August. A
good chance this will be the high of the year.
I fully realize these figures sound astonishing but we can hardly forget how far we’ve fallen. A rally of this
magnitude actually falls in line with (here’s the rhyme again) 1938 and 1974, which rallied 60% and 51%
respectively. The last emergence from a recession for the stock market was (another rhyme) March 2003
where it staged an unending rally till the end of the year with a trough to peak move exceeding 50%.
The mean cyclical return for the stock market in a secular bear market is 65% over 508 days. In addition,
volatility in the markets today is much greater than in previous periods. Ned Davis’s own estimates are that
the SP 500 could reach 1200-1300 by summer, which would be wonderful. But any rally that extends into
late summer will likely be running out of steam and showing signs of exhaustion and excessive enthusiasm,
this is the stage of the rally where we must be selling. The very same panic-stricken investors who are in
cash now will be rabid to gain exposure as performance envy kicks in. There is substantial career risk for
a portfolio manager to be in cash and show nil or negative returns when market indices are substantially net
positive for the year, the NASDAQ has already returned to positive for the year.
Post Rally: The present rally will be based on the presumption that the economy has bottomed but
investors will not have had the chance to factor in unintended consequences, especially inflation. Its my
guess that inflation will return as an issue but its clearly too early to profit from that at this point in time,
the prospects for deflation need to be cured first along with housing before inflation is a substantial issue.
If inflation remains in check and Treasury bonds remain relatively stable with low yields along with an
economy that shows improvement then the stock market should merely correct itself with the normal
seasonal weakness and not commence a new Bear market. Either way, I plan on sticking to discipline and
having minimal long stock exposure by late summer.
All the best,
Brad Pappas
March 29, 2009
