SandPointe_September Market Perspective 2014

download SandPointe_September Market Perspective 2014

of 25

Embed Size (px)


SandPointe Investment Perspective ----------------------------------------------------------------- Roger E. Brinner, PhD Chief Market Strategist and Co-founding Partner September 2014

Transcript of SandPointe_September Market Perspective 2014

  • 1. SANDPOINTE 1SandPointe Investment PerspectiveRoger E. Brinner, PhDChief Market Strategist and Co-founding PartnerSeptember 2014

2. SANDPOINTE 2SandPointe Investment Perspective By Roger E. Brinner, Chief Market StrategistThe Fundamental Investment Strategy View from Our One-Armed Economist President Harry Truman famously asked for a one-armed economist so that he could get an unequivocal, fact-driven assessment, rather than hearing on the one hand., but on the other hand In this, SandPointes first Investment Perspective, youll get this treatment. 3. SANDPOINTE 3SandPointe Investment Perspective By Roger E. Brinner, Chief Market Strategist and Bryce Quillin, Chief EconomistUS equities will benefit from another year of profit growth and P-E ratio expansion-Real GDP growth in the US is shifting from 2% to 3+% real growth rates) unlike others who have prematurely predicted acceleration, I have waited until the fiscal policy corrections were digested and wealth had been rebuilt to make this call-Confounding pundits who have repeatedly, mistakenly projected an imminent peak in profit margins for years (just because the profit/GDP ratio was higher than normal), profits will rise more rapidly than GDP based on rising capacity utilization rates, price inflation still exceeding unit labor cost growth, and diminishing interest burdens-Even if, as we believe, the competing 10-year Treasury yield is headed toward 3.5% or more within three years, this would still easily align with a trailing PE ratio of 23-plus versus 19 currently. 23.5, for example, implies an earnings yield (the inverse of the PE) of 4 % that would still exceed T-bonds, and then the equity investor also gets earnings growth and the bond investor gets nada-Another way of stating this is that the equity risk premium is still exceptionally, unjustifiably large and is taking its sweet time shrinking, even though the risk premia in bond markets are now at relatively low levels (e.g. the corporate Baa is 2.2% above the 10-yeaar Treasury versus 5.6% in 2008); Putin has scared the equity markets but they can rally strongly after his threats to Europe have been sized up and stabilizedLong-term Treasuries are dead men walking for the next 3 years: everyone should know the real after-tax return will likely be negative yet such bonds still sit prominently in portfolios-A year from now, the 10-year Treasury yield will be near 3% versus less than 2 % today, producing a 1 % total return with a capital loss of 1% offsetting the meagre coupon-Subtract 3% cost inflation and youre underwater if youre an endowment-Subtract 40% income taxes and 2% price inflation if youre a consumer, so welcome to the investor scuba-diving team-Three years from now the federal funds rate will be at least 3% (2% inflation target plus 1-2% real return at cyclical peaks) and I judge the 10-year Treasury will be closer to 4%, thus more capital losses to offset historically abysmal coupons-Why would a prudent investor accept such returns when the implied bond-equivalent long-term equity return is at least 11%: the 5 % current earning yield (i.e. 19 PE) plus sustainable earnings growth of 6%? 4. SANDPOINTE 4Equity Prices Respond to Four FundamentalsAbsolute and relative performance of US and global regional equitiesEarnings (Primarily Past 2 Years)Competing Yield On Risk-free Sovereign Fixed IncomePerceived Risk/ Uncertainty of Earnings Due to Stage of Business CycleAdditional Risks Due to Abrupt Changes in Regulations or Global Shocks 5. SANDPOINTE 5Profit Growth, Plus a Super-Rotation from Risky Treasury Bonds to Equities, Continues to Bode Well for US Share Prices-5051015 19811986199119962001200620112016 Bond Yield - Earning Yield 10-Year Treasury YieldS&P 500 Earnings Yield (E/P Ratio)History ForecastINCREASING RISK AVERSIONREVERSION TOWARD NORMAL RISK AVERSIONSPREAD WITH NORMAL RISK AVERSIONApril 2013 Forecast for S&P 500 price increase to Q2 2014: +26.2% Actual gain: +25.5% 6. SANDPOINTE 6Central Banks Dominate Short-and Long-term Interest Rate Behavior, Responding to their Legislated Mandates to Control Inflation and GrowthShort-term interest ratesJob GrowthCore and Overall InflationExchange RateQuantitative EasingThe Fed, the ECB, the Banks of England and Japan, and their Global Peers All React to National Conditions, with identifiable national sensitivities and timing/patienceAdditional Forces Critical to Sovereign Bond YieldsGovernment DeficitsPotential Election ImpactsSpecial Crisis SituationsLong-term treasury rates 7. SANDPOINTE 7-6-4-202468101214161820-6-4-202468101214161820 1960Q11962Q11964Q11966Q11968Q11970Q11972Q11974Q11976Q11978Q11980Q11982Q11984Q11986Q11988Q11990Q11992Q11994Q11996Q11998Q12000Q12002Q12004Q12006Q12008Q12010Q12012Q12014Q12016Q12018Q1 Fed. Funds Rate10-Year Treasury Note YieldPolicy Indicator: Job Growth+InflationThe Economic Indicators Watched by The Fed Are Calling for Rate Increases and Bond Markets Began Responding Last YearBond Yield and Fed Funds Rate vs. Policy Indicator (Sum of Inflation and Employment Growth(1960-2018)Extraordinarily Low Funds Rate 2009-2014 8. SANDPOINTE 8The Fundamental Investment Strategy View from Our One-Armed Economists (continued)In dollar terms, commodities also shouldnt offer any momentum plays to the investorWith the European Central Bank dropping euro interest rates as US rates rise, the dollar strengthens: it logically and empirically gains about 8% for each additional point of the US-Euro bond spreadRestrictive Japanese fiscal policy and Chinese growth targets also require easy monetary policyOther things equal, within 6-12 months, each percentage point rise in the dollar against a currency basket cuts dollar- denominated commodity prices for industrial metals, farm products, chemicals, and energy by 7-9%Gold and precious metals will be hard pressed to hold their value in a strong dollar, rising interest rate environmentLooking beyond mid-2015, there are reasons for concernKnow these two facts of postwar economics: 1) the US has never had a recession that wasnt preceded by significant Fed tightening; and 2) the Fed has never raised the funds rate by 3% without causing a recession (classic declining real GDP recession or moderate growth recession with rising unemployment due to too-tepid GDP growth)The Fed has announced it will raise rates beginning next year and continue until normal rates are establishedThe normal peak would be 4 % in that the inflation is targeted at 2% and the average funds rate when unemployment is under 6% (cyclical peak periods) is 2.6% above inflation; I expect a slightly lower 2018 peak in the 3 % to 4% rangeAs a result of this moderation, and the absence of a preceding overheated boom, I expect only a growth recession with 2% real GDP growth, slightly rising unemployment, and a brief profit retreatIn other words, 2016-2018 will be an extended balancing act by the Fed as it seeks to temper growth without reversing it; the mid-1990s are the best example of a successful maneuver of this type by the FedBoth equity and bond returns are likely to be low and volatile in this future stretch until the Feds degree of success is learnedSandPointe Investment Perspective By Roger E. Brinner, Chief Market Strategist and Bryce Quillin, Chief Economist 9. SANDPOINTE 9Global Economic Factors Drive All Commodity Prices, and Unique Supply Forces Impact Oil Prices in ParticularAll Commodities: Farm, Metals, Plastics, Energy, ChemicalsOil PricesGlobal GrowthGeneral Inflation (GDP Deflator)Dollar Exchange RateOPEC Oil ProductionNon-OPEC Oil and Gas ProductionCommon Demand Forces Affecting All Commodity PricesAdditional Supply Forces Affecting Oil PricesNew Technology for Oil and GasThe noise of severe weather, strikes, catastrophes, and other crises is dominated by these discrete fundamentals when the investor prudently steps back from daily and weekly data 10. SANDPOINTE 10Commodity Prices Have Cycled Massively, Consistent with Historical PatternsAll commodities are driven by three shared fundamentals:Exchange rate of dollar vs. other currenciesGlobal economic activityTrends in global GDP priceNote that in the graph, the simple sum of these 3 factors very closely matches the behavior of the average materials price indexOur econometric model creates a weighted sum that matches even betterSource: Global Insight, BLS, IMF0. 1988Q11989Q11990Q11991Q11992Q11993Q11994Q11995Q11996Q11997Q11998Q11999Q12000Q12001Q12002Q12003Q12004Q12005Q12006Q12007Q12008Q12009Q12010Q12011Q12012Q12013Q12014Q12015Q1All Prices Relative to 1990 Averages Indexed to 1990=1 GDP DeflatorExchange RateAverage Materials (Farm, Metals, Chemicals) excluding OilIndustrial Capacity UtilizationSimple Sum of 3 FactorsDrivers of Wholesale Materials Prices, 1988-2013 11. SANDPOINTE 11Commodity Prices Move in Parallel, with the Exchange Rate Acting as a Dominant Common ForceSource: Global Insight, BLS, IMFHistoric U.S. Wholesale Prices of Key Crude Commodity Groups, 2001-2015-30-20-10010203040% -90-60-300306090120120% 2001Q12002Q12003Q12004Q12005Q12006Q12007Q12008Q12009Q12010Q12011Q12012Q12013Q12014Q12015Q1Inflation vs. Year Ago Farm ProductsChemicalsOil Prices (Right Scale) Exchange RateMetals 12. SANDPOINTE 12Looking Beyond Mid-2015, There Are Reasons For Investor Concern Because The Economy Responds Predictably, Logically Strongly To Policy ShiftsNational Output, Employment, Interest Rates, Exchange RatesandDifferentials versus Other Nations/RegionsBusiness Cycleswith predictable sequences of strength and weakness for each asset classMonetary PolicyFiscal PolicyTrade and Capital PolicyRegulatory PolicyIf the wise investor looks beyond the noise of weekly data releases, trustworthy signals -- patterns based on good logic and theory-- are apparent and thoroughly investableTechnology and Entrepreneurial Zeal 13. SANDPOINTE 13Mone