Investment Postcards from Cape Town

The following paragraphs are excerpts from Thursday’s market musings by David Rosenberg, chief economist and strategist of Gluskin Sheff & Associates in which he deliberates the investment merit of corporate bonds versus equities.

“First, while Baa corporate spreads have narrowed sharply from their Armageddon highs, at 370 basis points they are still pricing in a very bad economic and financial market scenario - still wider than at any point of the 2001 or 1990 recessions or the 1998 LTCM/Russian debt default freeze-up. In fact, history suggests that the corporate default rate would have to rise well above 7% for corporate bonds to deliver negative returns with yields as high as they are at around 7¼%. In a 1¼% inflation rate world, this is a hefty 8½% real rate for investors to chew on. Not too shabby.

“The comparable yield in the equity market, depending on whether one uses reported or operating P/E multiples on forward or trailing earnings, is little better than 6½%. So corporate debt still trumps stocks. And what this 200 basis point ‘yield gap’ is telling you is that either corporate bond prices will need to rally more down the road or we need to start seeing corporate earnings growth recover sharply enough to pull those multiples down to more attractive levels.

“We went back in time to see what the typical one-year total returns for the S&P 500 when the starting point for the P/E multiple is in a 10x-20x range and we get any sort of positive earnings growth in the ensuing twelve months, and indeed that total return growth averages out to be nearly +15%. This is why the valuation is important - when the starting point on the multiple is closer to 30x, you need to see at least 20% earnings growth in the coming year to generate any positive returns in equities at all.

“Our analysis would seem to suggest, given the multiple that coincided with the market trough, and under the proviso that we at least see some moderate positive growth in corporate profits, that the March lows will hold. Our challenge now is navigating the forecast after a massive 40%+ rally that has already occurred without any evidence of a meaningful earnings turnaround. The onus was on the bears back in March; the onus is now on the bulls.

“Our point is that the equity market has already gone beyond - by a factor of three! - what is normal in terms of the returns it usually generates in a given year when the starting point on the multiple is low to mid teens and earnings are up, say, roughly 10%. In other words, there is a whole lot of good news priced into stocks at current price levels.

“From our vantage point, a pullback towards 800 on the S&P 500 would not only be justified under the prospective earnings landscape, but would likely also provide a welcome buying opportunity.”

Source: David Rosenberg, Gluskin Sheff & Associates - Pastry with Dave, July 2, 2009.

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The holiday-shortened week saw investors pondering the depth of the economic rabbit-hole. As investors vacillated, most financial markets were characterized by a roller-coaster ride. Friday’s worse-than-expected jobs data left no doubt that the economy was in recession.

The highlights of the week’s discussions were captured on video and are included in this video-o-rama compilation. Strutting their stuff was a star-studded cast including the likes of George Soros, Hugh Hendry, Dan Greenhaus, Paul Krugman, Bill Gross, Nassim Taleb, Jeff Immelt, Stephen Roach, Bob Prechter and Marc Faber.

As an aside, the weather in Europe - where I am spending two weeks with my family in Slovenia and Switzerland - has been characterized of late by endless thunderstorms. Strikingly, the economic mood is no less despondent than that of the holiday-makers trying to escape the ominous dark clouds. But wait, is that a forecast for better days ahead?

Elsewhere, the jail doors closed behind “evil” Bernie Madoff, sentenced to 150 years for his epic fraud.

The video clips kick off with Financial Times investment editor John Authers reviewing asset class movements of the past 12 months, and finishes with the delightful Yield curve mambo - swap spreads data pulled into Excel, mashed up a bit and set to music.

John Authers (Financial Times): A 12-month review
“John Authers, FT’s investment editor, reviews the last 12 months, looking across the asset classes, votality measures and default risks.”

Click here for the article.

Source: John Authers, Financial Times, July 1, 2009

The Wall Street Journal: Soros on market instability
“Soros Fund Management Chairman George Soros talks to WSJ Deputy Managing Editor Alan Murray about market instability and the difficulty for investors.”

Source: The Wall Street Journal, June 30, 2009.

CNBC: Hendry - print more money to avoid bigger slump
“Fears about inflation and hyperinflation could create another economic downturn, bigger than the one the world went through, Hugh Hendry, chief investment officer at hedge fund Eclectica, told CNBC.”

Source: CNBC, June 29, 2009.

Yahoo Finance, Tech Ticker: Fill or kill - strong case we don’t need Geithner’s toxic debt scheme
“PPIP, the Public-Private Investment Program, is the government’s controversial plan to spur buying of banks’ toxic debt. Since Geithner first floated the scheme in late March, bank stocks have rallied sharply and most big financial services firms have raised capital via equity sales - thanks, in part, to optimism about the PPIP.

“The irony, of course, is the plan hasn’t gotten off the ground and is hamstrung, most notably, by banks’ reluctance to sell their ‘assets’ at what they consider rock-bottom prices.

“There’s a strong case to be made we don’t need the PPIP anymore, says Dan Greenhaus, an analyst in Miller Tabak’s strategy group. At the same time, banks are going to be even less willing to participate now, since they’ve raised capital and the economy has shown signs of stabilizing.

“If Geithner’s goal was simply to inject confidence into the system so banks could raise capital, then PPIP really was ‘the greatest program that never occurred’, as Goldman managing director Scott Romanoff described it, according to The WSJ. Viewed in this light, Geithner might be wise to kill the program altogether.

“But if Geithner’s goal was really to get toxic assets off the banks’ balance sheets, the program has failed completely - or merits an incomplete at best. Against that backdrop, it will be interesting to see what Geithner says about PPIP this week, if anything.”

Source: Aaron Task, Yahoo Finance, Tech Ticker, July 1, 2009.

Charlie Rose: A conversation with Paul Krugman

Source: Charlie Rose, June 30, 2009.

CNBC: Bond king reacts to jobs data
“William Gross, co-CIO of Pimco, shares his reaction to Thursday’s jobs report.”

Source: CNBC, July 2, 2009.

(more…)

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As often stated in my weekly “Words from the Wise” reviews, a confidence indicator worth monitoring is the Barron’s Confidence Index. This Index is calculated by dividing the average yield on high-grade bonds by the average yield on intermediate-grade bonds. The discrepancy between the yields is indicative of investor confidence. There has been a solid improvement in the ratio since its all-time low in December, showing that bond investors are growing more confident and have started opting for more speculative bonds over high-grade bonds.

Source: Plexus Asset Management (based on data from I-Net Bridge)

Not surprisingly, a strong historical relationship exists between the Barron’s Confidence Index and the S&P 500’s 12-month rate of change.

Source: Plexus Asset Management (based on data from I-Net Bridge)

The improvement in the Barron’s indicator augurs well for the outlook for equities - specifically for the return of confidence - and provides further evidence that US stock markets are in all likelihood mapping out a base development formation. However, in the short term I still maintain it is quite likely that markets could consolidate further and possibly retrace more of the prior gains.

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The US Labor Department yesterday reported the labor market had performed considerably worse in June than had been expected. Nonfarm payrolls (jobs) fell by 467,000, following a loss of 322,000 in May, whereas the unemployment rate edged higher to 9.5% from 9.4% in May.

The disappointing jobs report highlighted the severity of the downturn and suggested a bottom for employment is not near. As hopes of an economic recovery during the second half of the year dimmed, the stock market indices declined sharply for a third consecutive weekly loss.

Putting the job losses in historical perspective, Chart of the Day produced a graph comparing job losses during the current economic recession (solid red line) to those of the last recession (dotted gold line) and the average recession from 1954-2006 (dotted blue line). Strikingly, the chart illustrates that the current job market has suffered losses that are nearly three times as much as the average. As shown, if this were an average recession/job loss cycle, the number of jobs would have started increasing three months ago.

Source: Chart of the Day, July 3, 2009.

In a related video clip, Bill Gross, co-chief investment officer of Pimco, shares his reaction to the jobs report and the consequences for the US economy.

The slide in employment is representative of what the US economy faces for years to come, Gross told CNBC. A slow-growth scenario continues to play out as consumers who are losing their jobs or are in fear of facing unemployment cut spending and inhibit economic growth, said Gross.

“Much like we saw with the Depression, attitudes change, and so consumers and investors will now become conservative savers as opposed to spenders. Spending as driven by asset appreciation in terms of houses …  that game stops, that game has stopped and we must now move in another direction.”

Source: CNBC, July 2, 2009.

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