Equity Market Review

Once again equity markets are looking vulnerable. The high octane markets in Asia such as Shanghai, HK and Bombay have certainly corrected sharply, and this amid quite benign news. How do we make sense of these markets? The retail investor and, quite embarrassingly, the professional investor panicked in the second half of 2008. Both retail investor, and again, embarrassingly, professional investor, missed the turn in 1Q 2009 but was happy to get into the market late in the rally. Most professional investors argued that the recovery was nothing but a bear market rally. Some, like the strategists at Goldman Sachs for example, believed that it was the beginnings of a V shaped recovery. We won’t know who is right until it is too late, too much time has passed, and its no longer important.

Emerging market crises of the past teach us that markets can exhibit very high volatility post a crisis. The strength of the first relief rally can be very strong and resemble a V shaped recovery. The subsequent reality can bring a market to new lows. The number of oscillations before a new cycle begins varies. 

The rally was a bear rally and its all over now:

• Economic fundamentals remain weak. The current recovery is based on a short term adjustment from inventory restocking.
• Employment numbers remain weak. Unemployment and weak personal income will cap consumption and thus a broad based recovery.
• Personal balance sheet repair will cap consumption.
• Credit may have eased up but this has been a transfer of risk from private to public balance sheets
• Fiscal and monetary policy will lead to unsustainable public debt levels
• Emerging markets seem to be recovering but the growth is driven by infrastructure and fiscal policy, the numbers are false, the recoveries are unsustainable, the recoveries are unbalanced.
• Earnings have beat forecasts but this is because forecasts were acutely over pessimistic to begin with – possibly because the crisis was concentrated and originated in the financial sector – where forecasters originate.
• Valuations are not compelling. The recent rally left equity valuations stretched since there has been no progress in fundamentals.
• There may be green shoots of recovery but these are very moderate recoveries from very depressed levels. Quarter on quarter or month on month numbers may be recovering but year on year numbers are still dismal.

The market is currently in a correction as part of a wider recovery, there is nothing to worry about:

• Fiscal and monetary policies are being operated on an unprecedented scale and will repair the economy – if not in real terms then in nominal terms.
• Policy makers will err on the side of caution and will continue reflationary policies well into recovery.
• Industrial production and capacity utilization are turning around.
• Consumer sentiment is lagging as unemployment is still rising.
• The recovery due to the inventory restocking is part of a more sustained recovery. It always starts with inventories.
• Jobless claims are still high but not rising.
• Economies are being reshaped. US and Europe export sectors are likely to grow at the expense of the domestic sector.
• China, Brazil, India and the Emerging Markets will generate sufficient economic growth to make up for the retrenching Western consumer.
• Every recovery has its beginnings in month over month improvements.

For every argument that the economy is on the way to recovery, there is another argument that it is doomed. The truth is somewhere in the middle. History repeats itself, but its timing is never precise. There is a segment of the market that expects equity markets to collapse into September 2009 in a repeat of 2008. Signals of these expectations are telegraphed into option open interest and trading activity. September 2009 will likely not see the same collapse. If there is to be a further bear market of the proportions of 2008, it is likely to manifest only once the investors who expected it to happen in September have waited sufficiently long past September to say that all is well and that the signs of danger were unwarranted.

An optimist is someone who believes that we live in the best of all possible worlds and that whatever the damage in the past, we will emerge stronger, eventually. The pessimist is someone who fears that this is true.

Unfortunately, especially for me, I cannot say where the market will go. My linear reasoning module tells me that the market will weaken into September, unwinding the excesses of the liquidity driven rally, not with the ferocity of the year before, but in continuous tradable fashion. I think that the market will need to consolidate before it makes a more sustainable fundamentally driven recovery. My non-linear reasoning tells me that the market consensus will be confounded and that the market correction will be short-lived, that policy will be more than supportive of risky assets, that negative expectations will lead to weak shorts and short covering, and that the rally will extend to the year end. Then we might get that almighty crash. Or not. I just think that the coming correction will be postponed until the experts and the stale bears throw in the towel and proclaim a new dawn.

Japan’s quarter on quarter GDP growth recorded a 0.90% increase versus consensus estimates of 1.0% and a prior quarter’s alarming 3.8% decline. There are several ways to read this. One is that growth was positive on a quarterly basis and we should all be thankful for it, let’s all go and buy equities. The other is that the number was below forecast and that the recovery is weaker than expected, this despite fiscal and monetary policy specifically designed to revived a critically ill economy, what a disaster, let’s all sell equities.

There is another angle. Japan’s economy was boosted by fiscal and monetary policy in the last quarter. The monetary policy can go on, the fiscal policy will be difficult given the parlous state of the public balance sheet.  With unemployment continuing to rise, retail sales showing no signs of strength and Japan’s natural export markets still weak, it is hard to imagine the recovery scenario. Inventory restocking can only take an economy so far.

Moreover, the GDP deflator came in well below forecast at a mere 0.50% year on year for the quarter versus a forecast 1.8% and a prior quarter’s 0.9%. For a country plagued by deflation this is potentially disastrous. (And implies an even weaker number for nominal GDP.)

Perhaps its time for consumption taxes, currently at 5%, to be stepped up by 2% per annum over the next 2 years.

Here is an analysis of the dispersion of returns in the various sectors of the European equity markets as defined by the Stoxx sub sector indices.

Dispersion here has been defined as the standard deviation of returns across the constituent stocks in a Stoxx sector index. I looked at 2 year daily data as well as 10 year weekly data.

The higher the dispersion, the more the variation of returns is explained by idiosyncratic risk and company specifics. This lends the sector to stock selection and fundamental analysis.

The lower the dispersion, the more the variation of returns is explained by systemic risk and sector specific themes. This lends the sector to thematic directional trading.

Up until 3Q 2008, Banks had low dispersion and traded as a bloc. Resource stocks have always traded with high dispersion across the time period. Oil and Energy has also displayed chronically high dispersion. Utilities, healthcare, food and beverage have all had chronic low dispersion and continue to do so.

During the crisis period of the last 12 months, dispersion was highest in Banks, Insurers, Resources and Oil. Dispersion in these sectors has most recently fallen back to a more normal range and within normal spreads to the other sectors.

The stability and moderate levels of dispersions in Industrials, Autos, Consumer goods lend these sectors to fundamental research and relative value investing.

Daily dispersions Last 2 years:

Looking more generally across the various sectors in the longer term chart, we see that dispersions were clearly higher in the years 2000 to 2004. Since 2003, as equity markets recovered from the recession and terrorist attacks of the years before, equity market dispersion was low as markets came to be driven by excess liquidity and low interest rates. For stock pickers and fundamental equity long short strategies, this was not a conducive environment. This observation confirms my assertion that the years 2004 – 2007 were the most difficult times to make money from fundamental stock selection and equity long short or relative value strategies. It was more productive to be outright long through the period and trade tactically.

Weekly dispersions Last 10 years:

The picture has certainly changed. While monetary policy has fueled a liquidity driven rally in global equities and dispersion has fallen substantially from the crisis months of late 2008 and early 2009, dispersions have not compressed to the levels seen in 2005 and the opportunity set for fundamental equity long short remains attractive.

There are of course more interesting and sophisticated strategies that can be used to capture the themes of dispersion such as outright correlation strategies involving long and short vega positions in index and constituent options but the alternative investment industry is having a difficult enough time explaining simple things to investors.