Sunday, April 19, 2009

Stock market - medium term outlook April 20

On March 19 on my last stock trading update I said.

"Basically I am waiting for a blow off top to put more shorts on. I will sell my shorts if there are real signs of a sustainable turnaround or if the market has a low volatility gentle trend upwards (as occurs in bull markets). "

Well I am still waiting! Markets worldwide have rallied a long way very quickly. I have basically continued making a Little money with short term trades but apart from small potatoes this rally has largely passed my by. Closed most short positions apart from one small one on the Spanish market and then opened a small new short on the US market on Friday.

I looked at stock markets in particular the US market from a macro perspective in January and then in February. The US market continues to lead other markets so remains the focus. Let's see how things as panning out from that perspective and what's changed. My new comments are in italics.

A. Economic fundamentals. Before things actually get better in the real economy the chronological steps we have to go through are:
1. Stop increasing the speed of deterioration
2. Continue to get worse but at a slower pace
3. Stabilise
4. Start to improve.

At this stage it appears we've reached point 2 the speed of deterioration has at least stopped increasing even though the speed of deterioration is still high. This is a step in the right direction in the last 2-3 months but still there's still a fair way to go and there are definite risks in ongoing problems given the underlying issues of high indebtedness and fragile financial systems still exist.

B. The scope of government action. The decrease in real GDP has occurred despite large stimulus and bank bailout measures and unprecedented monetary policy action. So there is not too so much more the governments can do without causing themselves significant long term problems (i.e. government deficits become to large for markets to believe they will be serviced and the Fed ends up lacking creditworthiness due to holding assists worth less than amounts lent).

No change here.

OK so that's the real economy but hasn't the stock market already fallen a lot and discounted these problems meaning we might have seen the bottom?

C. When in the economic cycle are equity returns usually strong? Research indicates that returns in stock markets are very high for 6 months starting in the last 6 months of recession or at the end of recession. So given we're very likely more than 6 months away from the end, and possibly years away, this suggests we should be vigilant for a possible stabilisation in the recession (particularly if its' not related to one off government stimulus responses which will have a temporary impact) but we shouldn't be too hopeful about strong equity returns from this point.

Some economists continue to forecast an end of the recession in 6 months time but they have been forecasting this for about a year now. We certainly seem closer to the end than 2 months ago but it's unclear if this is going to be an L or V shaped recovery at this stage and the finding on stock returns only applies to V shaped recoveries. Check out stock market returns in Japan over the last 15 years since their L shaped recession - terrible!

D. Are stocks cheap compared to earnings? Aggregation of earnings forecasts suggests that when looking at individual companies USA equity market earnings forecasts are way too optimistic given the bleak macro economic outlook. i.e. analysts forecasts are suggesting earnings will zoom up over the next year when clearly the economy looks tougher this year than last. Earning disappointments will lead to disillusion with the market and create strong downward pressure on prices.

Earnings forecasts have come down so there is less scope for disappointment but still earnings are on a downwards path and obviously stock prices have bounced so they certainly don't' look cheap compared to earnings. Based on the last quarter earnings for the SP500 of around $14 the PE of the market is around 60! Clearly banks losses will end at some point and that will drive earning up to maybe around 40 in the next year or two but even that is a PE above 20!

E. Are equity prices cheap compared to the asset values of the companies? Compared to valuation during the last few years yes prices are cheap compared to asset value. But historical standards during recessions equity prices are not cheap. Tobin's Q - The measure of equity prices to prices on assets on the books - is currently around 0.7 this typically bottom's at 0.3 during recessions. This suggests there is a long way to fall. i.e. over 50%.F. Are longer term technical indicators basing in preparation for a sustained rebound? Primary long term trends in all major stock markets are clearly down.G. What is driving equity term markets on a daily basis and does this gives us hope? Looking at the past 9 months the pattern in movement in daily stock prices is astoundingly consistent. Equity markets are rebounding based on possible government actions and falling on the reality of earnings and broader economic data. There is no other "story" of substance out there in the market. Given the size of the economic problem, governments cannot have an overwhelming impact. So once the reality of this hits the primarily stimulus in this market of this "Obama bounce" will be gone and traders will be focused on the bleak macro economic data and the bleak earnings data.

Stock prices around 1.9 times asset values so stocks are now more expensive than previously. Danger.

H. Will the new administration in the US make a difference? Sure they can take actions that will have positive impacts but they are still politicians in the same political, social, cultural and economic system and political/equity cycles suggest bad times ahead. Basically "on average" equity markets in the US perform well in the third and forth years of a presidential term and poorly in the first and the second years. My understanding of this is that in the third and forth years most presidents (and congress and the senate) worry about being elected next time so they need to get out there and sell a positive picture of the economy. However during the first two years they face the reality of not being able to fund all their promises and the opportunity to talk down things and blame their predecessor. No doubt Obama will "discover" things are a lot worse than he thought and he will not be able to follow through with campaign promises.

No change.

I. Buffet is buying so if I'm a long term investor isn't now the time to snap up some bargains? Yes Buffet has been buying (but generally getting a special deal rather than buying at market price as you would be). His interviews suggest he's buying based on his view that this is largely similar recession to the ones he has experienced since he started in 1954. There are two points here. One - this recession looks different in terms of the: possible insolvency of the banking system, the debt levels of the USA consumers and government and the massive bubble in house prices that still has a long way to bust . Two - Buffet doesn't try to time the market, he readily admits he usually buys in too early when the market falls and he buys stocks with very specific characteristics rather than the whole market (often at prices unavailable to others).

No change.

So in summary, things now look slightly more hopeful on the macro front but valuations are not cheap compared to usual recession values and there are significant dangers to any economic recovery when it occurs. One of these dangers is the damage that the unwinding of unprecedented Fed actions may cause. A second is the zombie banks, a third the perilous deficit and budget situations of governments worldwide and a forth the weak financial situation that consumers find themselves in the US and other developed countries I remain cautious in the market and continue to look for opportunities to short the market.