Musing on the Markets : Vinny Catalano

V Shaped Rally ≠ V Shaped Recovery

Vinny Catalano, CFA — Wed, 23 Sep 2009 16:56:00 GMT

Yesterday’s posted interview with David Malpass brings into sharp focus a key aspect of the US economic recovery that far too few investors are tuned into. Specifically, the underappreciated dynamic that second, third, and lower tier companies (the backbone of employment growth in the US) may not deliver the much anticipated above consensus earnings results this and future quarters ahead. Moreover, as the backbone of employment growth, weakness in second, third, and lower tier companies act as a depressant on wages, hours worked, and consumer sentiment. Therefore, how the US (and global economy) will reach a sustainable recovery without the US consumer is a riddle wrapped in an enigma.

Lacking a large exposure to global markets (where the growth is and where the weak US dollar helps deliver strong short term results), the SMIDS (small and mid cap companies) on down are vulnerable to disappointing investors with at or below consensus earnings results next month. In this regard, David points out in the interview that above consensus earnings results this coming 3Q09 for large and mega cap multi nationals may come to pass via pricing power pressures on all companies offset by volume growth courtesy a cannibalization of the units growth to lower tier companies.

(As a reminder, 2Q09 bottom line results surprised to the upside thanks to cost cutting, as top line growth was largely in line with expectations. In the current quarter ending next week, expectations are for above consensus earnings results produced by top line growth that surprises to the upside (with cost cutting is largely done). With the US economy still on its knees, it is hard to see how US domestic top line growth (revenues = price x units sold) can surprise to the upside. How this happens for companies that will not benefit from global markets (and a weak dollar) is a mystery soon to be revealed.)

Investment Strategy Implications

In a liquidity driven stock market, all logic goes out the window – for a while. Justifications for over valued markets abound. And buy high to sell higher becomes the music that all performance based investors must dance to. Phrases like “melt up”, thanks to expectations that the $3.5 trillion sitting in near zero percent money market funds will be forced into equities, is the support rendered for P/E ratios that warrant above average (i.e. 15 times) levels. Sound familiar?

In such times, a prudent investor is a contrarian investor. Momentum driven/fast money “investors” awaiting sideline money to sell to on the basis of melt ups and a sustainable global economic recovery rooted in a deleveraging US consumer may turn out to be a fantasy bubble about to burst.

Vinny Catalano, CFA, is President and Global Investment Strategist with Blue Marble Research (BMR). BMR publishes the "Sectors and Styles Strategy Report" newsletter, which contains the market beating Model Growth Portfolio. To learn about subscribing as well as other benefits, click here.

When, Not If

Vinny Catalano, CFA — Tue, 15 Sep 2009 15:24:00 GMT

Now that the S&P 500 has hit my full year target of 1050 (made last December 30 as published in the Wall Street Journal’s “MarketBeat” blog) - with 3 months still left to go, I might note, cyclical bulls (like me) who have turned increasingly more cautious over the past two months (as stocks moved well passed their fair value targets) continue to sell into the rally. The portfolio consequences of this sell-into-strength decision are two fold – reduced profits and reduced exposure to a pullback.

As stocks moved higher into overvalued territory, the first course of action was to maintain a portfolio’s equity exposure (assuming it was less than 100%) to the total assets managed, which for accounts managed by my company was in the low 90% range. When stocks continued to march ahead these past few weeks, the course of action shifted to reducing the equity exposure, which now stands in the mid to upper 80% range. This modified market timing (a/k/a sector and style tilting) works best in portfolios geared for the long term and subscribe to the diversification with a tilt approach to managing money*. Eventually, stocks that have taken a shine to the stratosphere will feel the gravitational pull of profit taking, common sense, and a cooling down of the animal spirits momentum “investing”. A correction then ensues.

On the assumption that a correction will eventually occur (and it will), the timing of the correction may be domain of the foolish and the insightful but the process is not. From experience investors should assume that one of the following will likely occur:

Air pocket – investors rise one morning to find stocks gap open to the downside in a big way. Volatility rises as price action becomes more erratic with many whipsaw movements. Bye bye steady up, hello wild and wooly.

Sudden but moderate – a decline starts and continues as market pundits proclaim the healthy qualities such a Goldilocks version of corrections exhibits.

Erosion – the decline sneaks up on you. Slow, steady, and highly corrosive. The flip side of the past several months. Of the three possibilities listed above, I would opt for #1, the air pocket. However, whatever correction does emerge, investors are best served by being clear about their portfolio strategy action steps before, during, and into a correction. I have articulated the general outlines of my approach. What’s yours?

Investment Strategy Implications

Eventually, stocks will experience a pullback. The gravitational forces of profit taking, common sense, and a cooling down of the animal spirits momentum “investing” will help markets absorb and reflect on where the fair value for an asset class belongs. At 1050, expectations now put stocks at 1170 (10% discount factor) 12 months hence, which means that operating earnings need to reach $78 by 3Q10 – a number that only the most optimistic of forecasters has recorded. Alternatively, there are those who argue that a higher than normal times P/E (15 times) is appropriate (e.g. due to low inflation, good rates of return on equity, large amounts of liquidity still sitting on the sidelines), despite the fact that so much remains highly uncertain. All things considered,

When, Not If appears to be a good investment conclusion to reach at this time. And being a contrarian investor (as opposed to a follow the crowd momentum “investor”) means taking money off the table is a prudent course of action at this time.

*see my August 27 Minyanville article

Vinny Catalano, CFA, Global Investment Strategist with Blue Marble Research publishes the "Sectors and Styles Strategy Report" newsletter, which contains the market beating Model Growth Portfolio. To learn about subscribing as well as other benefits, click here.

When Goldman Talks, Investors Listen

Vinny Catalano, CFA — Tue, 21 Jul 2009 14:46:00 GMT

For the past two months, I have made the argument that above consensus macro economic data would lead to above consensus earnings results and that investors would see the evidence of this as 2Q09 earnings season got underway. Based on the reports issued thus far, this argument has won the day as above consensus earnings results have matched the above consensus macro economic reports preceding them. Accordingly, stocks responded.

The second part of my argument was that such positive data would eventually encourage bottom up analysts (along with many investment strategists and top down economists) to reassess their more cautionary views and begin to raise their full year earnings expectations for this and next year. This, too, has begun to occur – none more significantly than from the investment strategy folks over at Goldman.

In a research report published yesterday, the Goldman strategists raised their estimates of S&P 500 operating earnings for this and next year - from $40 to $52 and from $63 to $75, for 2009 and 2010, respectively. In the process, the group estimated the target fair value for the S&P 500 at 1060 – ten points above my best guesstimate for the year (as reported in the Wall Street Journal on December 30, 2008) and my more evolved view of the same number based on the simple math of the historical average P/E of 15 times a mid 2010 estimate of $70 = 1050. As John McLane (“Die Hard”) might say, “Welcome to the party, pal”.

With Goldman in tow and many fence-sitting traditional money managers and individual investors being forced to reconsider the wisdom of leaving $3.5 trillion in money market funds earning 0.1%, the more meaningful investment strategy question is “Where are we in the stock market cycle?”

Investment Strategy Implications

As expressed in this week’s research report to subscribers, stocks are clearly in extreme overbought territory at the top end of the range. A completed bottom has not occurred. Therefore, stagnation (at best) or a pullback (most likely) appears to be in the very short-term offing for stocks.

That said, each week provides more evidence that the global economy has moved further away from the economic abyss of early March. Now that monetary stimulus and creative governmental action has done its work, the bulk of the fiscal stimulus package (conveniently timed for the 2010 election cycle) will provide the needed power to move the economic needle from stabilization to growth.

Aided by the global growth story (from emerging economies) as well as the likely positive forces of the wealth effect (from higher financial asset values), corporations, having demonstrated their ability to manage solid results in times deep economic distress, should be able to generate very satisfactory earnings results in an overall improving global economic climate - including a modest contribution from the US consumer.

So, where are we in the stock market cycle?

Stocks appear to be well into a transitional phase – one in which sector (style, country, and regional) rotation will (must?) produce the new leadership necessary for a new bull market to sustain itself to 1050 and beyond. The rotation to new leadership coupled with a completed bottom are the stock market signs most worthy of investor attention.

Patience, The Lost Virtue

Vinny Catalano, CFA — Tue, 02 Dec 2008 18:09:00 GMT

As the alternate universe of derivatives continues their great detoxification unwind, financial assets struggle to comprehend a world in transition to a new financial and economic order. In the process, fixed income markets remain frozen while equity markets lurch from one end of the prospective economic spectrum to the other in near 1.0 correlation.

Investment Strategy Implications

The derivatives tail continues to wag the cash market dog. For traditional investors (those who still believe in things like earnings, P/E ratios, and Discounted Cash Flow models), the only path through this chaotic, cold-turkey transition from an economically juiced, over leveraged, structurally imbalanced world to a less leveraged, more balanced one (e.g., global growth being less dependent on the US consumer) is patience. The alternative is to sell everything and hope that one is smart and quick enough to time their re-entry point.

Investors (in the true sense of the word) will follow the former while traders will choose the latter.

The Not-So-Smart Smart Money

Vinny Catalano, CFA — Wed, 26 Nov 2008 01:40:00 GMT

It should be fairly evident by now that heavy redemptions at hedge funds over the past two months contributed significantly to the recent pounding in the one area where markets are liquid – stocks. Moreover, the deleveraging process continues to impact many hedgies as available capital (for leveraged strategies) has dried up*.

Accordingly and in anticipation of continuing redemption demands (many of which remain unsatisfied due to gating), many hedge funds have sold more than has been requested thus far. Lastly, there is some talk that private equity commitments of institutional investors are also forcing redemptions in their hedge fund holdings.

Investment Strategy Implications

With the market cap of the S&P 500 sitting at $7.4 trillion and money funds (institutional and retail) amounting to more that $3.3 trillion, the momentum nature of hedge funds and their high cash positions would only need a less bad environment (see Barton Biggs’ comments in yesterday’s Financial Times) to trigger a stampede back into equities.

With valuation currently at deep recession (bordering on depression/deflation) levels, any earnings surprises into 2009 (as in something north of $70) would be the justification for buying what was just sold.

*One wonders what has transpired behind closed doors between financial institutions and government re lending to the masters of the universe.

Krugman and El-Erian in the Valley of FUD

Vinny Catalano, CFA — Wed, 19 Nov 2008 12:43:00 GMT

In his excellent book, “When Markets Collide”, PIMCO chief Mohammed El-Erian writes about the journey and the destination that the global economy and markets are undergoing and puts in context and helps clarifies much of the current economic and financial chaos. In it, Mr. El-Erian describes a world that will be but is clear to note that the process of getting there may be “bumpy”.

Nobel laureate Paul Krugman points to the same concept in his blog posting yesterday (“After the Stimulus”) in which he lists the components of the US economy for 2007 and their averages from 1979 to 2007. As the accompanying table from his blog shows, the economic mix of the US economy got to be quite imbalanced primarily due to credit inspired high consumption levels by the US consumer. In the process, net exports became the counterbalancing force*.

As El-Erian declares in his book, a transformational world (economic and financial) is inevitable and has been underway for some time (long before the current credit and now economic crisis). And Krugman states, “Consumption probably isn’t going back to a 2007 share of GDP — savings are back. So what will fill the gap, once the stimulus is gone? Housing? Not for a long time. Business investment? Hard to see why. The natural thing would be to trade lower consumption for a smaller trade deficit.”

It is logical to assume that the US economy will experience two mega trends in the coming years:

• US consumer spending will fall while US consumer savings rise (aided by the baby boomers’ need to provide for their retirement years now that the wealth effect has gone kaput) • Net exports will improve as global growth, particularly in emerging markets, continues to expand (certainly relative to developed economies)

It is also likely that non-residential investments (capex) will move closer to their average as corporations retool to meet the global export opportunities while government spending will increase as the US government seeks to stabilize the US economy (large fiscal deficits and other government programs like TARP).

Investment Strategy Implications

The bottom line for those investors willing to look beyond the valley of FUD (fear, uncertainty, and doubt) that we are currently wallowing in is to position their portfolios (what’s left of them) to exploit these mega trends. To follow this direction, however, requires context, perspective, and perseverance – something sorely lacking in a panic stricken financial climate. *table contents

C = Consumer N = Non residential investment (capex) R = Residential investment (housing) G = Government expenditures NX = Net exports (exports minus imports)

Just How Bad Are Corporate Profits?

Vinny Catalano, CFA — Tue, 18 Nov 2008 16:02:00 GMT

Today's earnings report from Hewlett-Packard raises the question posed in this blog postings' title. To help shed some light on the subject, consider the corporate results produced thus far re 3Q08.

Compiled each week from data published in the Wall Street Journal (and produced for subscribers in each weekly report along with more than a dozen other charts and tables), the accompanying table* shows that when you exclude Financials & Energy, the earnings results are less than great but nowhere near as dire as the headlines and sound bites would led investors to believe. Moreover, the quarter over quarter results ex Financials show a net gain.

That said, several items warrant comment:

* Autos (Consumer Goods) had the largest swing from horrendous (-$42.6B) to just plain bad (-$2.5B)
* Broadcasting and Airlines hit the Consumer Services sector with negative swings of $17.5B and $3.5B, respectively
* Conventional Electricity (Utilities) were hit hard due to higher energy costs to the tune of $-5.3B

Going Forward

Needless to say, investing is a forward looking game. Guidance has ranged from cautious to the ever dangerous "challenging". Despite this fact, however, most bottom up analyst projections remain in what could only be classified as the enthusiastic category, as evidenced by 2009 S&P 500 operating earnings estimated in $90 range.

While obviously overly optimistic, the bottom up boys and girls' forecast may not be too terribly off the mark as lower energy costs and a more robust global growth scenario turn out to be two of the surprise events of the new year. Then there is the very serious prospect of write-ups in Financials as assets held get mark to market upward should any return to normalcy in debt and credit related assets pricing occur.

Investment Strategy Implications

Doomsday scenarios abound. The headlines are awful. And while the credit markets show some progress, the TED spread remains elevated as the improvement in LIBOR is offset by the deflation/depression fear driven levels in the 3 month US Treasury rate.

Thankfully, the equity markets are now past the November 15th notification date for hedge fund redemptions, which should alleviate some of the forced liquidations that have roiled stocks over the past six weeks. However, unmet hedge fund redemptions linger as something of an overhang remains (gradual liquidations replaced hurried forced liquidations) as does tax related selling by individual investors.

Lots of conflicting factors at play. Then again, what would you expect during the bottoming process of one of the worst financial and economic episodes in history?

For Whom The Deep Oversold Bell Tolls (again)

Vinny Catalano, CFA — Wed, 12 Nov 2008 18:40:00 GMT

Whatever the fundamental rationale may be – November 15th and hedge fund redemptions; capital gains sales in anticipation of tax increases next year; fears of a global recession; concerns re FAS 140 and QSPEs (more on this one in a future posting); S&P 500 earnings closer to $50 with a 10 or less P/E – the technicals of the market are once again on the verge of signaling another strong non-confirmation low.

As the accompanying chart shows, the deep oversold in Slow Stochastics (below 20) combined with a vastly improved Momentum and MACD readings point to a bell ringing non-confirmation low. In my experience, when combined in this fashion these indicators have a > 80% probability of success. And when they fail, the worst-case result is breakeven.

Investment Strategy Implications

Will this time be different? Perhaps, but only the nightmare scenario of plunging earnings and deflationary level P/Es justify lower prices.

Beyond the Sound Bite: An Interview with Sam Stovall

Vinny Catalano, CFA — Wed, 05 Nov 2008 17:47:00 GMT

My conversation with Standard and Poors' Equity Research Chief Investment Strategist includes how stocks tend to perform when one party controls government, fourth quarter of an election year stock performance, first year of a new administration and stock performance, and the earnings estimate split between bottom up analyst forecasts versus top down driven estimates.

The length of the interview is 13 minutes 30 seconds.

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An Overbought Pause

Vinny Catalano, CFA — Tue, 04 Nov 2008 14:05:00 GMT

As delightful as the rally has been, a key super short-term technical indicator, Slow Stochastics, is registering an overbought reading (above 80) and a cause for a pause.

As the accompanying chart* shows, while the near-term indicators, Momentum and MACD, are in fine shape (especially MACD) and supportive of further market strength, Slow Stochastics suggest that the market may have reached a near-term peak.

As was the case with the recent oversold levels and near unanimous non-confirmation readings, overbought readings are abundant (most indicators registering the same readings) and give further evidence of a peaking out in the rally.

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Beyond the Sound Bite: My Interview on NPR

Vinny Catalano, CFA — Wed, 08 Oct 2008 10:27:00 GMT

The folks over at National Public Radio noticed my blog posting of yesterday re the credit markets, Treasury yields, LIBOR, and the TED spread and did an interview with me on the topic, which you can listen to by clicking on the following link.

To listen to the 20 minute interview, click here.

Note: To track the all-important TED spread, click here

Beyond the Sound Bite: An Interview with Vitaliy Katsenelson, CFA

Vinny Catalano, CFA — Wed, 28 May 2008 09:55:00 GMT

My conversation with the Director of Research for Investment Management Associates and author of "Active Value Investing: Making Money in Range-bound Markets" includes the rationale why equities are in a range bound market, the "active value investing" approach to stock selection versus traditional value investing, and the process of identifying attractive stocks in a range-bound market climate.

The length of the interview is 12 minutes 16 seconds.

(Please visit the site to view this media)

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To view this month's free sample report, click here.

Quotable Quotes: The Art of Deception

Vinny Catalano, CFA — Fri, 23 May 2008 09:44:00 GMT

It is fascinating to listen to all the pundits wonder just when Senator Clinton will drop out of the race. What amazes me is how they accept at face value her statement that she will stay in the race “until we have a nominee”. To most, that means whenever either candidate reaches 2026 delegates. However, for those of us schooled in the language of Clinton-speak (the meaning of is is), perhaps it means when the Democrats actually have a nominee – which, by the way, isn’t until the convention in August.

Therefore, to the beer –chugging Senator from Arkansas (via New York) on this Memorial Day weekend in the US let me offer these words from a person who did not dodge a bullet from a sniper:

“You may deceive all the people part of the time, and part of the people all the time, but not all the people all the time.” Abraham Lincoln

Have a good weekend.

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Beyond the Sound Bite: An Interview with Art Hogan

Vinny Catalano, CFA — Wed, 21 May 2008 06:26:00 GMT

In my interview with the Director of Global Equity Products for Jefferies & Co. we explored his shallow recession call, fairly strong operating earnings outlook, sectors (and industries within) that look attractive and ones to avoid, and the influence and importance of hedge funds.

The length of the interview is 18 minutes 2 seconds.

(Please visit the site to view this media)

*To view a sample report, click here.

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W (not the movie)

Vinny Catalano, CFA — Tue, 20 May 2008 00:24:00 GMT

The economic debate seems to have settled into which letter best fits the future trend of the US economy: V, U, L, or W?

The most bullish group, which includes many in the Goldilocks-redux crew, believe in the down (maybe strong) then up US economic scenario. V for victory, perhaps. Then there is the down then flat group, differing only in whether an upturn occurs sometime in the foreseeable future. U shows eventually, L says “who knows when?”. Some days things look up versus down and dirty for longer than you think.

The last group is the double dip club, my group. The US economy rebounds this year emboldening the Goldilocks dreamers to spout out their dreams of an economic “morning in America”. Unfortunately for them, the false dawn will result in a “mourning in America” when 2009 rolls around and the tailwinds of the stimulus package give way to personal economic reality for many US consumers.

Driven by a negative wealth effect, US consumers spend less and save more for that retirement rainy day as concerns over Social Security and a diminished asset base begin to change habits. Such a change will take time, however, as the spending addiction of US consumers still has some strength to it – a strength that will likely exhaust itself in the morphine known as the stimulus package, fiscal and monetary.

Investment Strategy Implications

Oliver Stone may be working on a movie about George W. Bush titled “W”. But investors will likely spend more time next year focused on another W – the double dip in the US economy.

Short term, equities will likely continue to benefit from the dreams and hopes of the Goldilocks crew. And investors should continue to exploit that fantasy. However, a changed business model for most financial institutions will contribute to a diminished level of credit creation stimulus for the US economy, which when combined with a less profligate, more frugal US consumer will coincide with a new domestic political dynamic leaving only emerging markets to save the global economic day. And that may turn out to be more difficult than it appears.

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