Tuesday, September 14, 2010

Morning Note...


Futures ~20bps lower despite better-than-expected Advance Retail Sales (+0.4% vs. +0.3%/exp) for August.  The NIFB Small Business Optimism Survey was slightly lower than expected at 88.8 vs. the 89 estimate, but grew versus the prior 88.1 reading.   This morning’s BofAMLCO Global Fund Managers survey was also relatively gloomy in sentiment terms – see more on that below.  In Germany, the ZEW Investor Sentiment Survey fell to a 19-month low and European markets are slightly lower.  Asia was mixed to slightly higher overnight.  Oil is down 25bps, Gold is up 1.15%, and the USD is relatively flat.  In earnings news, Best Buy (BBY; +8%) is higher on blow-out earnings and a forward guidance raise for Full Year 2010.  Kroger (KR; +3%) is also higher after they beat by 5c/share.  In research news, GSCO raised the Telecom Services sector to Overweight, raised Consumer Staples to Overweight, lowered the Industrials sector to Neutral, and lowered the Energy sector to Neutral.  GSCO also downgraded Campbell Soup (CPB) to Sell and OPCO cuts KLIC to Underperform.  In other news from the research side, I thought this piece from Sanford Bernstein on the future of capital markets was particularly interesting (bold emphasis mine):

The Street's long-suffering equity business saw its agency trading model largely fade away in the early years of this decade due to the implementation of execution rules and the growth of algorithmic trading. In response, the Street's equities businesses shed expenses, resized its sales force, research teams and block trading desks and modified its business model. Today, Wall Street's major institutional equities franchises rely on scale economics, execution technology, internalization, complex derivatives product suites, shared profits from ECM and proprietary trading to generate performance.

Now, the new Dodd-Frank legislation will force even more change on the business by prohibiting proprietary trading, constraining derivative revenues and thus lowering revenue return on net assets (RONA). So the business is once again facing a difficult environment – ROEs are likely to decline and institutional equities will have to revise its business model once again.

Pro forma for presumed new regulation, Bernstein estimates that the institutional equity divisions of Wall Street can generate only an 8.2% ROE on equity execution and can generate a ROE 11.8% on their combined equity execution and ECM business through the cycle. For an industry that has cost of equity capital of 10.4%, this not an acceptable outcome.

Fortunately, the Street and its clients will have time to prepare for this brave new world. It will be 6-18 months before the regulators announce the over 200 new rules and regulations mandated by Dodd Frank. And this delayed implementation of the Dodd-Frank Act, combined with the expected cyclical recovery of North American retail flows and volumes and equity underwriting activity in 2011-2012, will provide a period to adjust business activities.

To offset the economic impact of the regulatory changes we expect that successful equity divisions will tightly constrain their capital and balance sheet allocations. Equity divisions will be forced to ration their balance sheet and will provide liquidity only to their closest and most profitable clients. This likely means that successful client tiering and customer profitability systems will become even more critical. Free liquidity and the loss leading bids provided by the block trading desks of the street will become a thing of the past. Bernstein expects that price for execution services firms increases over time as demand for execution services outstrip the balance sheet capacity allocated to the business by senior management.

Prime brokerage will remain a key offering of equity divisions attempting to capture flow and lock in client relationships and revenue sources. Technology and execution speed will remain the battle ground of the business. But the idiosyncratic trading characteristics of equities and the “story aspects” of individual stocks will keep trading from ever becoming fully “electronic”.

The successful equity business models that emerge will balance several factors to achieve reasonable returns: (1) the need for trading volume in scale and access to low cost source of liquidity such as retail flow; (2) the costs of customer support and of technology; and (3) the expected equity underwriting market share. To get to these new and (hopefully) successful models, the core execution and research businesses still need to go through restructurings to allow the business to achieve reasonable return on the equity it employs. This likely means that compensation expense and headcount will decline to offset the revenue losses of Dodd-Frank.

Among the many industry participants there are three clear leaders at this point - Goldman Sachs, Morgan Stanley and Credit Suisse. These three firms have maintained a lead in technology offerings, have strong equity capital market league table rankings, and have either had historically strong prime brokerage franchises (GS and MS) or a rapidly growing market share in the business (Credit Suisse).

For the bulls, here is one trader’s contrarian take on the world, especially in light of the most recent fund manager’s survey:

Good Morning – Global Fund Managers survey is out this morning, and there appears to be high levels of pessimism.   Investors cautious, risk averse, poorly positioned for any upside surprises; growth expectations stagnant, margin expectations down, cash levels up. Optimism scarce and concentrated on EM equities, China economy and cheap equity valuations. 3/4 investors forecast below trend growth and inflation; notable drop in expectations for corporate profit margins; but net 11% expect stronger China growth, up sharply from the pessimism of recent months. Falling bond yields encouraged investors to embark on a yield hunt with the largest sector moves being into utilities (now only net -11% UW from -27%), telcos (+10% OW from +4%) and pharma (+17% from +12%). Tech remains the most popular sector at +25% but is sharply down from its 6m high of +46%.    We have been range bound since early May.  1030 vs. 1130.  Until we break either way things will likely remain stagnant.   There are plenty of articles on the capital markets.  WSJ talks about the number of launches in the first week,  post Labor Day.  Retail sales sets the tone.  I am still a buyer of the dips.  Long term the market seems to be in good shape from here.   Have a good day. 

And for the contrasting bearish view, a recent SocGen research report from Albert Edwards is absolutely scathing and well-worth a read – please see the Quote section below for the full piece, as pasted from the John Mauldin weekly email. 

POOL tgt cut at PIPR.  MBTN SW upgrade at UBSS.  FBRC cuts GWW.  MSCO ups WIN.  BofAMLCO cuts ETR.  BCAP cuts ARNA.  JEFF cuts IPXL, SKH.  MSCO cuts BOH, NWL.  OPCO cuts RTEC, TER, VRGY.  WEFA cuts ARST. 

S&P 500 PreMarket 8:30am (last/% change prior close/volume): 



Today’s Trivia:  Any guess at to the connection between Willy Wonka & The Chocolate Factory and William Wallace of Braveheart fame?

Yesterday’s Question:  What is hotter, a lightning strike or the surface of the Sun?

Yesterday's Answer:  A lightning strike (54,000° F) is roughly 6 times hotter than the surface of the Sun.

Best Quotes: 

Market still deluding itself that it can escape the inevitable dénouement
By Albert Edwards
The current situation reminds me of mid 2007. Investors then were content to stick their heads into very deep sand and ignore the fact that The Great Unwind had clearly begun. But in August and September 2007, even though the wheels were clearly falling off the global economy, the S&P still managed to rally 15%! The recent reaction to data suggests the market is in a similar deluded state of mind. Yet again, equity investors refuse to accept they are now locked in a Vulcan death grip and are about to fall unconscious.
The notion that the equity market predicts anything has always struck me as ludicrous. In the 25 years I have been following the markets it seems clear to me that the equity market reacts to events rather than pre-empting them. We know from the Japanese Ice Age and indeed from the US 1930's experience, that in a post-bubble world the equity market merely follows the economic cycle. So to steal a march on the market, one should follow the leading indicators closely. These are variously pointing either to a hard landing or, at best, a decisive slowdown. In my view we are poised to slide back into another global recession: the data is slowing sharply but, just like Japan in its Ice Age, most still touchingly believe we are soft-landing. But before driving off a cliff to a hard (crash?) landing we might feel reassured when we pass a sign that reads Soft Landing and we can kid ourselves all is well.
I read an interesting article recently noting the equity market typically does not begin to slump until just AFTER analysts begin to cut their 12m forward EPS estimates (for the life of me I can't remember where I read this, otherwise I would reference it). We have not quite reached this point. But with margins so high, any cyclical slowdown will crush productivity growth. Already in Q2, US productivity growth fell 1.8% - the steepest fall since Q3 2006.Hence, inevitably, unit labour costs have begun to rise QoQ. This trend will be exacerbated by recent more buoyant average hourly earnings seen in the last employment report. Whole economy profits are set for a 2007-like squeeze. And a sharp slide in analysts' optimism confirms we are right on the cusp of falling forward earnings (see chart below).
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I love the delusion of the markets at this point in the cycle. It bemuses me why investors cannot see what is clear as the rather large nose on my face. Last Friday saw the equity market rally as August's 67k rise in private payrolls and an upwardly revised July rise of 107kbeat expectations. But did I miss something? When did we switch from looking at headline payrolls to private jobs? Does the fact that government is shedding jobs not matter? Admittedly temporary census workers do mess up the data, but hey, why not look at nonfarm payroll data ex census? Why not indeed? Because the last 4 months run of data looks notably weaker on payrolls ex census basis than looking only at the private payroll data (ie Aug 60k vs 67k, July 89k vs 107k, June 50k vs 61k and May 21k vs 51k). But these data, on either definition, look dreadful compared to the 265k rise in April and 160k in March (ex census definition). If someone as pathologically lazy as me can find the relevant BLS webpage after a quick call to the BLS (link), why can't the market? Because it is bad news, that's why.
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August's rebound in the US manufacturing ISM was an even bigger surprise. This is a truly nonsensical piece of datum as it was totally at variance with the regional ISMs that come out in the weeks before. The ISM is made up of leading, coincident and lagging indicators. The leading indicators - new orders, unfilled orders and vender deliveries - all fell and point to further severe weakness in the headline measure ahead (see chart above). It was the coincident and lagging indicators such as production, inventories and employment that drove up the headline number. Some of the regional subcomponents (eg Philadelphia Fed workweek) are SCREAMING that recession is imminent (see left hand chart below).
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The real reason why markets reversed last week was that they got ahead of themselves. Aside from the end of 2008, government bonds were the most over-bought they had been over the last decade. And in equity-land the AAII two weeks ago recorded a historically low 20% of respondents as bullish (see chart above). These technical extremes will now be quickly worked off before the plunge in equity prices and bond yields resumes.
I am often asked by investors with a similar view of the world to my own (yes, there are some),whether the equity market will ever reach my 450 S&P target because of the likelihood that further Quantitative Easing will prevent asset prices from falling back to cheap levels.
Indeed we know that a central plank of the unhinged policies being pursued by the Fed and other central banks is to use QE to deliberately target higher asset prices. Ben Bernanke in a recent Jackson Hole speech dressed this up as a "portfolio balance channel", but in reality we know from current and previous Fed Governors (most notably Alan Greenspan), that they view boosting equity and property prices as essential for boosting economic activity. Same old Fed with the same old ruinous policies. And by keeping equity and property prices higher, the US and UK Central Banks are still trying to cover up their contribution towards the ruination of American and British middle classes - (see GSW 21 January 2010, Theft! Were the US and UK central banks complicit in robbing the middle classes? - link).
The Fed may indeed prevent equity prices from slumping with any QE2 announcement. But this sounds a familiar refrain at this point in the cycle. For is monetary easing in the form of QE that different from interest rate cuts in its ability to boost equity prices? Indeed announced rate cuts in previous downturns often did generate decent technical rallies. But in the absence of any imminent cyclical recovery, equity prices continue to slide lower (see chart below). The key for me is whether QE2 can revive the economic cycle, not equity prices temporarily.
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In the absence of a cyclical recovery I cannot see how QE is any different in its ability to revive asset prices than lower rates in anything other than a temporary fashion. (Interestingly many of our clients think QE2 might give a temporary fillip to the risk assets but that the subsequent failure to produce any cyclical impact will cause an extremely violent reaction as investors lose faith in QE as a policy tool and Central Banks in general.)
If we plunge back into recession, do not place too much confidence in the Central Banks having control of events. As my colleague, Dylan Grice, said last week "let them keep pressing their buttons." Ultimately they cannot fool all of the investors, all of the time.