Snoopin' Through the 'Ville
Good to see you Tony!
Note: The following commentary is offered with educational intent and is no way intended as advice. Old school Minyans will remember that Tony shifted his posture to a more constructive (bullish) posture in June. The critters and I welcome Tony's view as he is a true friend and a good man.
After a better than expected employment report and subsequent financial market action, our old friends at the "Whacko News Network" (WNN) gave us a call for a mock on-air live television interview. This is how it went...
Anchor: Good morning Tony, it has been a while since we spoke. When we last spoke, rates were heading down despite strong economic growth. What do you say now that interest rates increased as March payrolls surged?
Tony: It was great to see payrolls surge, but frankly interest rates were coming from historically depressed levels (Exhibit 1) and payrolls were already trending higher. If you take out the few months when war with Iraq was inevitable through the end of the war, employment growth is on a similar trajectory to the recovery following the 1990 recession (Exhibit 2). Friday's employment report served as confirmation the uptrend in payroll growth remains in place. In fact, FTN Financial's own Chris Low made mention that once payrolls pass the +200K level, they generally accelerate suggesting further employment gains.
Anchor: Isn't it bad for the equity market when rates rise?
Tony: It depends on the degree and sustainability of the higher rates. For example, look back to last summer where the spike in rates was much more dramatic. From June 13th to September 2nd, the 10-year Note yield went from 3.11% to 4.6%, a spike of 150 basis points. During that period, the Standard & Poor's 500 Index (SPX) gained 3.4% and is up 11.7% since hitting 4.6%. The one thing we know for sure...if rates rise here, it will be the most widely advertised move in the history of the financial markets. Typically, the most negative impact on equities is felt when no one expects a significant hike in rates, ala early 1994, when the Fed double the Fed Funds Rate. In addition, we don't expect a Fed rate hike until after the November elections, which means another 6+ months of high stimulus.
Anchor: Ok Tony, let's cut right to the chase...walk us through your fundamental thesis on the equity market.
Tony: Ok, we can do that. First, one has to make an inflation assumption in order to determine an interest rate outlook. In doing that, we use the Core CPI...
Anchor: Wait a second pal, why would you exclude food and energy? Are you telling me you don't use either? I mean come on...
Tony: Better watch your tone before we lace you like a shoe! We use the Core CPI rate for two reasons. First, the Fed mentioned they are using it in their last post FOMC meeting statement. Second, it correlates more closely to the 10-year Note yield than does the overall rate (Exhibits 3&4). The bottom line is that it doesn't matter if it is right or wrong...it just is what works the best and at present the Core CPI has yet to even bottom. Even in the higher inflation 70's it took months and sometimes many quarters before it trended sustainably higher (Exhibit 5). Basically, that means interest rates should remain relatively stable (stable can mean a gradual move higher). We believe the market and economic stats still give the Fed plenty of time to wait for more data. As you know, the Fed generally does what the market tells it to. The bottom line is that even on an uptick, inflation and rates remain historically low and are likely to stay that way through this year.
Anchor: Even if rates and inflationary pressures do remain stable, albeit at higher levels, aren't valuations too high historically, and don't they have to get back to extreme low levels in order to expect the "secular" bear market is over?
Tony: The common argument in the bearish camp is that valuations have to fall below the mean and get back toward 10 before the market can make a real "bear market bottom." The only problem with that argument is, in a low inflation, tame interest rate environment, valuations don't have to get back to historic lows before the market can rally. Let's use the last post recession market cycle as an example. Valuations didn't actually reach a low until the SPX made a new high in the beginning of 1995. From then on, valuations expanded in 1995 and never reached anywhere near the historic lows that have to be seen in order to suggest a major market turn (Exhibit 6).
Anchor: Let me make sure I am following your thesis right...so your view is that inflation remains historically low, market and Fed driven interest rates move gradually and valuations should remain near where they are. So what will be the driver for equities? Even the growth rate of earnings should begin to decelerate going forward.
Tony: Earnings should be the driver and historically, and despite conventional wisdom, equity prices movement is more closely correlated to $ change and not % change in earnings (Exhibits 7&8). That is a very important point. Since 1982, the only time equities have seen a sustainable decline, it was associated with declining earnings and not a deceleration in earnings growth.
In addition, we believe earnings may prove to be conservative. It is hard to believe that CEO's and Analysts are overly optimistic in era of watching their peers go to court or get dragged though the mud for being too bullish during the bubble. Evidence of this is in the First Call Inc. consensus estimate for '04 and '05, which have been revised higher each month (Exhibit 9). Again, we know company managements and fundamental analysts have historically been overly optimistic, but it is important to remember the equity market suffered a historic decline in 2000-2002.
Anchor: If you take all these factors into account, what is your fundamentally driven target on the SPX?
Tony: We like to keep it really simple. We use the current market multiple on trailing 12-month operating earnings of 20.6 and multiply that to the First Call Consensus estimates (as provided by Baseline Inc.) for 2005 of $67.19. That would yield a target of 1,384 over the next 12-months.
Anchor: 1,384? Don't you think that is a little high?
Tony: Well, actually we are trying to be conservative by not assuming any multiple expansion off of the recent valuation low. I guess in order to suggest it is an outlandish forecast; one would have to assume expectations of an earnings collapse or anticipation of a sustainable valuation contraction despite inflation and interest rates being historically low...even if they spike. Think about this though...a move to just 1,300 would suggest well above consensus gains of 14% from current levels.
The reason higher rates negatively impact the equity market is that in the normal cycle, the Fed tightens its way into a recession. This in turn causes earnings to drop instead of simply slowing. Remember the correlation of S&P price is to $ change in earnings. We are a very long way from the Fed tightening enough to generate a recession. In the beginning of 1994, the Fed doubled rates from 3% to 6%, which didn't cause a recession. Investors are unlikely to even see the first hike until the latter part of this year.
Anchor: We shall see...this interview has gone on long enough...would you mind coming back to share with us your views on the technical backdrop for equities?
Tony: It would be my pleasure. I love the name of your channel - especially because it exists only between my ears and has a very appropriate name.
Graphs courtesy of Baseline Inc.
Todd Harrison is the founder and Chief Executive Officer of Minyanville. Prior to his current role, Mr. Harrison was President and head trader at a $400 million dollar New York-based hedge fund. Todd welcomes your comments and/or feedback at firstname.lastname@example.org.
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