Recovery Is Still in the Eye of the Consumer
By James Kostohryz Oct 06, 2009 1:50 pm
Their actions, or lack thereof, will determine the financial future. Until then, we wait.
Second, and most importantly, nothing much has changed.
In terms of fundamentals, the economic data is sending mixed signals. However, I remain constructive because of the favorable technical environment.
I have only two positions at this point representing about 15% of the portfolio -- Bank of America (BAC) and Apple (AAPL). The rest is in cash.
I was stopped out of the modest short I had on gold (GLD) today. My fundamental outlook on gold remains unchanged, as laid out in Will Gold Stay in A Sweet Spot?
Gold will act as a cyclical. If growth is good, gold will rally, even if it's less than other cyclicals. If global growth falters, gold will falter, perhaps severely.
Regarding my overall outlook for financial markets, looking forward, I believe one must take into account the fact that earnings season has been a major positive catalyst for financial markets during the last two quarterly reporting periods. In this regard, I expect the trend toward positive earnings revisions to continue. This obviously has bullish implications.
However, I don’t have a more aggressively bullish stance because earnings data is fundamentally backward looking.
This wouldn’t be a problem in the context of a strong economic recovery. However, the more forward-looking economic data points are flashing some mixed signals regarding the recovery.
Ultimately, one must assess the market on a forward-looking basis, and I confess to be uncertain about the medium-term economic outlook. I believe it could go either way.
My own investment philosophy is that high-frequency trading tends to lead to mediocre results. The best results are attained when major "bets" are limited to situations in which an “edge” is clear.
This doesn’t happen that often. It happened to me in mid-2008 when I predicted a meltdown of financials and oil, and it happened to me again in March of 2009 when I predicted a major counter-trend rally.
Right now, I don’t have a clear edge on the short- or medium-term future for the market. Therefore my overall exposure is light. And I will probably remain “light” on my Minyanville postings until I see another major opportunity. That could happen in a week or in a couple years.
In articles such as Solving the Consumer Demand Dilemma, I’ve outlined some of the key indicators I’m looking at closely. The Institute for Supply Management Services Index is one of those indicators, and today’s number provided a positive sign.
I suggest that investors monitor everything related to private consumption. And when looking at indicators of private consumption -- whether they’re anecdotal or statistical -- be empirical. Forget your ideological biases.
Everything hinges on the aggregate behavior of consumers. If consumer data perks up, the pick-up in the economy won’t be a temporary phenomenon. The recovery will become self-sustaining -- even if it’s just for one business cycle.
On the other hand, if private consumption patterns falter, the current pickup in production activity won’t be sustainable and the economy will experience a “double dip” -- only that the second dip could be more of a crash.
This is the current dilemma. Contrary to popular belief, debt levels aren’t a major impediment to reigniting and sustaining another business cycle. There’s plenty of scope for consumers, businesses, and government to sustain and even significantly expand current debt levels. And banks have plenty of liquidity and capital to expand credit.
The only real impediment to a sustainable recovery is ultimately in the minds of consumers.
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No positions in stocks mentioned.
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Reply
2009-10-06 14:40:05
the (a) mind of the consumer -
well, in general, all i can say is i'm hearing more and more of people cutting "way" back for the holiday shopping, but i've heard that before and seen different ;-)
but, for myself and my wife, we're tighter than a jar of grandma's preserved peaches waiting for the right season to open up, and it ain't right now -
just some anedotal data from one nuclear family ;-)
but, for myself and my wife, we're tighter than a jar of grandma's preserved peaches waiting for the right season to open up, and it ain't right now -
just some anedotal data from one nuclear family ;-)
2009-10-06 16:03:16
Consumer recovery
James, good call on counter trend recovery. Althought it was bosted due to the government putting its stamp on bank's crappy balance sheet, once it was clear that there is no way the government would let banks falter, the counter trend rally was likely to be "real".
The bear case of course is based on the fact that handoff from government to consumer won't happen. I think that's taking too simplistic a view, there remains a segment of the consumer which can take on more debt (as you say). As to banks lending, that is a bit more suspect. I don't think it is as simple as you say. Banks need to hoard excess cash because they still have to absorb losses from junky assets. And NIM is getting harder as the 10 year rallies and yield curve flattens. Off B/S lending is still sputtering. Still, as risk appetite expands, banks could lend out at the margin to decent credit consumers and large corporates. Of course, one can argue that the better credit consumer can take on more debt than the sub prime consumer too, so there is some likelihood of consumer debt coming back.
BTW, income growth can be ruled out as a possible driver of the economy (with 17% U-6). So the consumer has to re-leverage (even if modestly) to spur a self sustaining growth.
What I really question though is whether a modest pickup in consumer borrowing and bank lending is sufficient to bring growth back to 2007 "LEVELS". The YoY (or MoM) % growth aside, there is a large output gap between 2009 and 2007 due to the severtity of the recession. I am no economist, but it is fairly simple math to show that growth needs to be well above trend to get the economy back to anywhere near 2007 levels. If 2007 level of GDP was driven by a debt fueled binge, where sub prime consumers, off B/S lending, 30x leveraged banks turned the spigot on, then, in the absence of a good chunk of consumers not borrowing or being able to borrow, little to no off B/S lending, regulatory controls that limit bank leverage, banks needing to hoard capital to protect agains losses still on their books, how can the LEVEL of GDP be reached?
2011 S&P consensus operating EPS is $93 (higher than 2007 EPS!). For that to be feasible, the 2007 LEVEL of GDP needs to be achieved. As the market sees that this is not possible, it will sell off. No armagedon or crash, but a sell off.
Add to the above fundamentals, some "minor" issues such as CRE, high government deficit, high unemployment (and importantly low "employment"), further foreclosures etc. and I would argue that you can't even pay normalized S&P multiples of 16x on operating EPS (I realize that in a low interest rate environment, multiples tend to be high, but I am not sure that one can make a thesis that low rates will remain for a long enough time for the multiple to be high).
You made a good call, supported by the markets buying into the government backstop of banks. Perhaps revisit the bull case based on the above? Or maybe you have a case for cosnumer borrowing/income growth and bank lending being so strong as to deliver 2011 operaying EPS that is higher than 2007 (and therefore GDP growth being so strong as to make up for all of the lost output gap due to this recession and more)? If you do, you believe that reflating asset prices is single handedly sufficient to make up for all that lost output in about 2 1/2 years....god bless you if you can make that conclusion!
Long story short, James, while your thesis is correct, you fail to analyze it in sufficient depth to make a case for higher markets from here. You were right at S&P 666, and you make a case for markets higher than that, but is there a good case for S&P 1200? For that to happen, operating EPS has to come in at $75 (which as I have argues before is unlikely even with some borrowing, some lending, and very small but not much income growth). The multiple also has to be 16x, which also is unlikely, given that amount of uncertainty in the economy.
The bear case of course is based on the fact that handoff from government to consumer won't happen. I think that's taking too simplistic a view, there remains a segment of the consumer which can take on more debt (as you say). As to banks lending, that is a bit more suspect. I don't think it is as simple as you say. Banks need to hoard excess cash because they still have to absorb losses from junky assets. And NIM is getting harder as the 10 year rallies and yield curve flattens. Off B/S lending is still sputtering. Still, as risk appetite expands, banks could lend out at the margin to decent credit consumers and large corporates. Of course, one can argue that the better credit consumer can take on more debt than the sub prime consumer too, so there is some likelihood of consumer debt coming back.
BTW, income growth can be ruled out as a possible driver of the economy (with 17% U-6). So the consumer has to re-leverage (even if modestly) to spur a self sustaining growth.
What I really question though is whether a modest pickup in consumer borrowing and bank lending is sufficient to bring growth back to 2007 "LEVELS". The YoY (or MoM) % growth aside, there is a large output gap between 2009 and 2007 due to the severtity of the recession. I am no economist, but it is fairly simple math to show that growth needs to be well above trend to get the economy back to anywhere near 2007 levels. If 2007 level of GDP was driven by a debt fueled binge, where sub prime consumers, off B/S lending, 30x leveraged banks turned the spigot on, then, in the absence of a good chunk of consumers not borrowing or being able to borrow, little to no off B/S lending, regulatory controls that limit bank leverage, banks needing to hoard capital to protect agains losses still on their books, how can the LEVEL of GDP be reached?
2011 S&P consensus operating EPS is $93 (higher than 2007 EPS!). For that to be feasible, the 2007 LEVEL of GDP needs to be achieved. As the market sees that this is not possible, it will sell off. No armagedon or crash, but a sell off.
Add to the above fundamentals, some "minor" issues such as CRE, high government deficit, high unemployment (and importantly low "employment"), further foreclosures etc. and I would argue that you can't even pay normalized S&P multiples of 16x on operating EPS (I realize that in a low interest rate environment, multiples tend to be high, but I am not sure that one can make a thesis that low rates will remain for a long enough time for the multiple to be high).
You made a good call, supported by the markets buying into the government backstop of banks. Perhaps revisit the bull case based on the above? Or maybe you have a case for cosnumer borrowing/income growth and bank lending being so strong as to deliver 2011 operaying EPS that is higher than 2007 (and therefore GDP growth being so strong as to make up for all of the lost output gap due to this recession and more)? If you do, you believe that reflating asset prices is single handedly sufficient to make up for all that lost output in about 2 1/2 years....god bless you if you can make that conclusion!
Long story short, James, while your thesis is correct, you fail to analyze it in sufficient depth to make a case for higher markets from here. You were right at S&P 666, and you make a case for markets higher than that, but is there a good case for S&P 1200? For that to happen, operating EPS has to come in at $75 (which as I have argues before is unlikely even with some borrowing, some lending, and very small but not much income growth). The multiple also has to be 16x, which also is unlikely, given that amount of uncertainty in the economy.
2009-10-06 16:42:21
Consumer recovery
Hari:
You make many good points.
First, I am not a raging bull at this point. I recognize many of the bearish factors you point out. As I state in the article, I am merely constructive for technical reasons, with an 80% cash position.
However, I think that you may be overstating the bear case based on some of your analysis. Much of your analysis seems to hinge on the idea that it will be difficult for US GDP to regain 2007 levels by 2009. There are several potential flaws with this line of analysis. First, the level of GDP in any given year is really not that important. Using earnings or GDP in any given year and applying a multiple to it is one of the most common mistakes and misperceptions out there. What matters is the level of GDP and earnings over an entire business cycle. Suppose that the 2007 GDP level is captured in 2012 rather than 2011. In a long term valuation model, the difference it makes is negligible. The important question to be asking is not what 2011 GDP will be -- it is how long and strong will the next business cycle be?
Second, you must not equate US GDP and earnings too closely. Other factors must be taken into account. First, international exposure represents 35% of GDP. Second, S&P 500 may gain market share over non-S&P 500 companies. Finally, S&P 500 companies may be disproportionately exposed to higher growth segments of the economy.
Finally, when one analyzes valuation models one comes to the conclusion that valuation only matters at extremes. From a statistical point of view, if you run the data since 1870, the probabilities associated with S&P 1,350 are virtually the same as those at 950. The difference in terms of probability analysis are negligible. Thus, don't get to hung up on a “fair value” number. If the S&P can reach 1,100, it can reach 1,300 quite easily. Historical analysis of valuation demonstrates that the difference between these two valuation levels is negligible.
You make many good points.
First, I am not a raging bull at this point. I recognize many of the bearish factors you point out. As I state in the article, I am merely constructive for technical reasons, with an 80% cash position.
However, I think that you may be overstating the bear case based on some of your analysis. Much of your analysis seems to hinge on the idea that it will be difficult for US GDP to regain 2007 levels by 2009. There are several potential flaws with this line of analysis. First, the level of GDP in any given year is really not that important. Using earnings or GDP in any given year and applying a multiple to it is one of the most common mistakes and misperceptions out there. What matters is the level of GDP and earnings over an entire business cycle. Suppose that the 2007 GDP level is captured in 2012 rather than 2011. In a long term valuation model, the difference it makes is negligible. The important question to be asking is not what 2011 GDP will be -- it is how long and strong will the next business cycle be?
Second, you must not equate US GDP and earnings too closely. Other factors must be taken into account. First, international exposure represents 35% of GDP. Second, S&P 500 may gain market share over non-S&P 500 companies. Finally, S&P 500 companies may be disproportionately exposed to higher growth segments of the economy.
Finally, when one analyzes valuation models one comes to the conclusion that valuation only matters at extremes. From a statistical point of view, if you run the data since 1870, the probabilities associated with S&P 1,350 are virtually the same as those at 950. The difference in terms of probability analysis are negligible. Thus, don't get to hung up on a “fair value” number. If the S&P can reach 1,100, it can reach 1,300 quite easily. Historical analysis of valuation demonstrates that the difference between these two valuation levels is negligible.
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