Archive for February, 2013

The “Great Rotation” and Risk

The FundLogik Application continues to point towards a risk weighting. For most portfolios, that means a shift towards equities and away from fixed income.

Last week, we looked at one of the main currents of money flow which drives global financial markets. This week, we look at the factors which drive the money flows into one of the key asset classes available to investors: Equities.

How Wall Street views Equities

According to the collective judgement of investors on Wall Street, a dollar of earnings this year will cost $15 if you select the average Blue Chip stock from the S&P 500. And, for the optimists in the room, that $15 dollar figure for stocks falls to $12.30 if one looks forward to 2014 earnings rather than backwards to 2012 numbers. That same dollar of earnings will cost you $50 if your tastes run to 10 Year US Treasury Bonds. As bond interest is fixed, there is no need to calculate a rosy scenario.

To Wall Street strategists, this big price difference between equities and fixed income suggests an imminent “Great Rotation” from bonds to stocks as rational investors rebalance between relatively expensive bonds and cheaper equities.

Three Factors

Three FactorsAre they right? The answer is yes but probably not for the reason usually pushed to the front of the research report (stocks are cheap, bonds are expensive). There are three factors which drive stocks and stock markets: Earnings, Interest Rates and Risk.

Earnings: Supportive of Equities

If you limit your focus to quarterly earnings and consensus forecasts, you will see an exciting jump in expectations at the beginning of this year. The numbers that go into the overall S&P 500 estimate are important because most institutional money is benchmarked to the index or a close derivative thereof. If you are interested in some of the key biases which drive the consensus forecast process, ZeroHedge has an insightful article on the subject.

Earnings pop
Source: Bloomberg

Before one gets too excited, let’s step back and view a couple of years at once. The phenomenon highlighted with the small red arrows is known as “earnings roll.” Analysts, who are employed by brokerage firms in the business of selling stocks to clients, push their numbers up in the beginning of the year and then adjust them as quarterly reports come out.

Earnings roll
Source: Bloomberg

So, if you look at the red line on the second chart (which charts the running 12 month forward forecast), earnings are moving in a positive direction but not dramatically. This is supportive of the market but not enough to make the case for a “Great Rotation” on its own.

Interest Rates: Neutral for Equities

This is an easy call because all the Central Banks are working in concert to keep a lid on interest rates. These generational lows in US dollar interest rates have hardly spurred the borrowing and investment boom that some Keynesians had expected. But with debt levels reaching what some consider dangerous levels relative to GDP, few G-20 countries want to think about servicing their debts at high single digit interest rate levels. Rising rates are bad for stocks, falling rates are good. Interestingly, there are new studies suggesting that low and steady levels of interest rates do not correspond to above average stock market returns while high and steady do not necessarily mean poor performance. With no movement expected up or down, this part of the equation is neutral.

Risk: Positive for Equities

The Chicago Board of Options Exchange has an excellent index for measuring the level of risk in the short term (ie. a matter of a month or two) called the VIX. Although this is often cited as The Fear Index in the market, it is important to remember what it is actually used for on a day-to-day basis: pricing options. A high reading certainly does reveal high anxiety in the market and a low reading, relative calm but the measure is by design a short term one.

The risk we are trying to measure is the certainty of forecasts. To give a simple example, the range of expectations for a consumer products company like Proctor and Gamble are much narrower than they might be for United Continental. While the former may stumble in an emerging market or be subject to margin squeeze, the latter can see profits quickly turn to losses with an adverse move in jet fuel prices. Broadly speaking, the tighter range of expectations command higher Price/Earnings ratios (P/E) while the broader range means the company (or the market) is accorded a lower P/E.

Macro factors can also be measured in a similar fashion. When the range of possibilities are uncertain (think some of the hyperbolic commentary ahead of the “Fiscal Cliff”), investors respond with caution and P/E ratios tend to fall. When uncertainties drop away, investors are willing to bid up asset prices and P/E multiples expand.

With the European Central Bank commitment to support the Euro at almost all costs, the passing of the “Fiscal Cliff” and the realization that the trajectory of US Government Debt issuance is likely to pursue a more sedate upward trajectory while the underlying economy continues to grow at a lower but sustained pace, some of the big worries in the market are being calmed.

If one wants a proxy (rather than anecdotal assurances), a reasonable measure of longer term anxiety is the spot gold price. With the arrivals of ETFs, gold is certainly cheaper to hold but the shiny metal still provides no income. Investors buy gold because they are willing to forego income to hedge against the risks they perceive in other asset classes. The FundLogik application and just a cursory look at the charts show that the upward trajectory of gold has cooled dramatically.


The FundLogik application has been flashing “Buy Riskier Assets” since November last year. Now we are starting to see that the market has been a good leading indicator as the conditions for better earnings and a less volatile environment shape up.

Keep holding onto the riskier end of your watch lists…and as they say on the airplane, “sit back, relax and enjoy the ride.”

US Trade Deficit and the “Great Rotation”

Now that we have milked “January Effect” for a nice return, it is time to look forward to the medium term. This idea will take two letters to flesh out. This first part will set up the conditions; the next will describe the catalyst.

Weather and Markets

As the Northeast digs out of its blizzard, it is hard to resist a reference to the weather and its causes.

Growing up in New York, one is introduced to the concept of the Gulf Stream Current in grade school with a few interesting facts:

  1. New York City is roughly on the same latitude as Madrid and Naples.
  2. London’s latitude would put it on the southern shore of Hudson Bay in Canada.
  3. There are palm trees sprouting near the southwest tip of Ireland.
>Palm Trees in IrelandI cannot vouch for the palm trees but the other checkable datapoints suggest that the Gulf Stream is a critical part of what makes Western and Northern Europe quite a bit warmer than one might expect. With an estimated 100x the total global energy demand contained in this “river through the Atlantic”, the Gulf Stream has energy to spare for generating and feeding hurricanes that we give names like Katrina and Sandy.

Ocean currents are both powerful and not immediately obvious to the observer on or near the water. The first map of the Gulf Stream was published by our ambassador to France, Ben Franklin, who gathered data from American captains. When he tried to clue the British in on his findings, he was rebuffed. As a result, American shippers were able to beat the leading global maritime power by a significant margin on trips from England to the US for a number of years in the early days of the Republic.

Early Map of the Gulf Stream
Source: Wikipedia

What do currents have to do with the market?

Moving from weather and shipping to the market, the markets also have a current which is known but largely overlooked by the financial media. The largest and most powerful single part of the global economic engine is the US Trade Deficit, currently running at $40bn a month. When US consumers purchase more oil and widgets from other nations than they export, a stream of US dollars are sent overseas to settle the balance. That’s about an Apple Inc. a year ($450bn market cap).

US Trade Deficit (Monthly)
Source: Bloomberg

Exported dollars become imported capital

Those US dollars must return to the US to purchase assets. Sometimes the actual recipient will invest directly but mostly the dollars end up with larger government and sovereign wealth sized entities as exporters turn in their excess dollars for local currency to pay running costs. Those US dollars are aggregated and used to purchase a combination of deposits in banks, property, debt instruments or equity. There have been some fads and there have been some constants. US Treasuries and Agencies have always been a popular choice, particularly for the managers of “foreign exchange reserves” (Central Banks or Sovereign Wealth Funds).

Why Treasuries are always popular

The US Treasury market remains the most liquid of the financial markets. Even after S&P’s downgrade, the question of security has never been a serious issue. In addition to the policy demand from the Federal Reserve, Treasuries have remained the most popular choice for the foreign currency reserve manager. Those two sources of demand have pushed Treasury prices up to what some consider bubble levels and interest rates down to generational lows.

Property and Equity (M&A)

But there have been other bouts of enthusiasm. Large Japanese companies went for property and corporate buying sprees in the late 80’s and early 90’s (remember Pebble Beach and Rockefeller Center?). European corporates have not been shy about snapping up large US rivals when the opportunity has arisen (who makes Bud Light?). And more recently, Chinese State Owned Enterprises have been deploying some of the Chinese cash pile into corporate projects.

The Mortgage Boom

Even though US Agencies like Freddy Mac and Fanny Mae have always been on the shopping list, the biggest boom in recent times has to be the Securitized Mortgage Boom from 2000 to 2008. For those few years, the demand for CMOs and their alphabetic siblings was nearly bottomless as Sovereign Wealth Funds called their bankers in New York and London to put money to work. Mortgages were no longer a cottage industry run by Savings and Loan officers in towns across the US whose banks wore the risk on their books. The loan officers were turned into buyers for the mass production lines run out of the money center banks and investment banks to feed the demand for homogenous, commoditized product. We all know how that ended.

Continuation of the Treasury Bull market

Since 2008, the weight of funds has been towards the short and medium portions of the US Treasury market. Foreign Reserve Managers have not been terribly interested in the long end of the market which is why “Operation Twist” was deemed necessary by the Federal Reserve. There was plenty of demand for the bills and notes that the FED swapped out of to buy the longer term bonds. The FED’s goal was to flatten the yield curve but it would have inverted (short rates higher than long rates) if the underlying demand for the securities the FED was swapping out of had not been there.

Where do we go now? Great Rotation?

Now that we have identified the strongest current of capital flow in the ocean of money that forms the Global Financial markets, will there be any asset class shifts this year which might lead to relative outperformance?

One potential change being touted is the “Great Rotation” into equities by some analysts on Wall Street. From the equity side of the equation, it would not take a massive shift of funds to have an outsized impact on equity prices.

In the 80’s and 90’s there was some equity participation by offshore investors but as we can see from the charts, the total amounts ($10bn monthly deficits) were smaller. Now we are talking about a much larger “river” of capital which needs to be invested. Until the maturation of the ETF product, which allow investors to efficiently and anonymously buy entire indices, it would be difficult to argue that Sovereign Wealth Funds could participate meaningfully in equities because of liquidity constraints.

Means and Opportunity

The funds are in the market as a result of the US Trade Deficit and the opportunity to invest in other asset classes exists with the mass adoption of ETFs. But, as any seasoned investor knows, the necessary conditions are only part of the equation. The investors will need a catalyst to shift their asset allocation assumptions.

And now for Motive

Are we on the cusp of that asset allocation shift or has January been a temporary blip of enthusiasm? In our next newsletter, we will explore the one factor that may tilt the balance in favour of equities. If we are right, what has been termed a “melt up” could become a full fledged bull market move.

Stay with the “risk on” trade for now.