Words from the (investment) wise for the week that was (July 27

For some reason the lyrics of Electric Light Orchestra’s classic, Livin’ Thing, keep resounding in my head: “You took me, ooh, woah, higher and higher, baby. It’s a livin’ thing … ” Followed by: “It’s a terrible thing to lose … ” But let me get on to the review of the financial markets …

Investors (or should I say “Johnny-come-latelies”?) last week again favored the reflation trade on the back of better-than-expected US earnings announcements and economic data, indicating that the trough of the recession might be behind us, or at least be stabilizing at depressed levels.

Newsweek’s cover declared: “The recession is over”, but a footnote stated “Good luck surviving the recovery”, implying a hard and treacherous slog ahead - note the pin below the “liquidity-inflated” balloon.

Tempering the bullish sentiment, David Rosenberg (Gluskin Sheff & Associates) commented as follows on Friday’s announcement of a 1.0% (quarter on quarter annualized) contraction in Q2’s real GDP: “While we are past the most pronounced part of the downturn, it may still be premature to call for the end of the recession merely because of the prospect of a positive third-quarter GDP result. After all, we saw GDP advance at a 1.5% annual rate in last year’s second quarter, and if memory serves us correctly, the NBER did not subsequently declare the end of the recession. And even if the recession is ending, as we saw in 2002, that does not guarantee a durable rally in risk assets. Sustainability is the key, and it remains the wild card.”

Many global stock market indices reached new highs for the year during the course of the week, and the S&P 500 Index closed in on the roundophobia 1,000 level. Other beneficiaries of investors’ continued interest in risky assets included commodities, oil, gold (rebounding strongly after a midweek sell-off of $24 an ounce), high-yielding currencies and corporate bonds. On the other hand, the US greenback remained out of favor and the Dollar Index closed the week at its lowest level for the year as investors shunned safe-haven assets.

The past week’s performance of the major asset classes is summarized by the chart below - a set of numbers that again indicates investors’ increased risk appetite. In the case of government bonds, a lukewarm response to the US GDP report took the edge off a poor response to the massive issuance of paper by the Treasury.

A summary of the movements of major global stock markets for the past week, as well as various other measurement periods, is given in the table below. As the second-quarter corporate results in the US came in thick and fast, the American and other markets extended their rallies to three straight weeks in most instances. As a matter of fact, if not for the down week of the Dublin ISEQ Index, the entire table would have been green. But then again, “green shoots” seem to be frowned upon by many pundits.

The MSCI World Index (+1.7%) and MSCI Emerging Markets Index (+2.5%) both made headway last week to take the year-to-date gains to +13.5% and an imposing +48.8% respectively.

As seen from the table, July was a solid month for stock markets with all the major indices recording positive returns. The Dow Jones Industrial Index had its best month since 2002 and the S&P 500 Index, Nasdaq Composite Index and Russell 2000 Index all recorded a fifth successive monthly gain, but were trumped by the Chinese Shanghai Composite Index that notched up seven consecutive positive months.

Stock market returns for the week ranged from top performers such as the Czech Republic (+8.7%), Kazakhstan (+8.5%), Turkey (+8.2%), Indonesia (+6.3%) and Kyrgyzstan (+5.8%) to Slovakia (-6.3%), Greece (-3.6%), Nepal (-3.0%), Ecuador (-2.2%) and Macedonia (-1.5%) at the other end of the scale.

The Shanghai Composite Index has surged 87.4% in 2009 as $1.1 trillion of bank loans and government spending stimulated economic recovery. Notwithstanding its gain for the week, the Index plunged by 5.0% on Wednesday - its largest decline in eight months - on speculation that the government might curb inflows into the stock market. “The government is worried that this bubble is becoming too big so they’re going to cut credit growth by probably half in the second half,” remarked former Morgan Stanley chief Asian economist Andy Xie. “I think the property and stock markets will come under pressure around October,” he said in a Bloomberg interview.

Of the 97 stock markets I keep on my radar screen, a majority of 74% (last week: 82%) recorded gains, 22% showed losses and 4% remained unchanged. (Click here to access a complete list of global stock market movements, as supplied by Emerginvest.)

John Nyaradi (Wall Street Sector Selector) reports that as far as exchange-traded funds (ETFs) are concerned, the winners for the week included KBW Regional Banking (KRE) (+11.1%), MarketVectors Indonesia (IDX) (+9.2%), PowerShares Global Gold and Precious Metals (PSAU), and United States Gasoline (UGA) (+6.7%).

At the bottom end of the performance ranking, ETFs included “all things short” such as ProShares Short Financial (SEF) (-3.6%), ProShares Short MSCI EAFE (EFZ) (-3.1%) and ProShares Short Russell 2000 (RWM) (-2.3%).

As far as the thawing of the credit crisis is concerned, junk bond yields continued declining, as shown by the Merrill Lynch US High Yield Index (and also by the good performance of the iShares iBoxx $ High Yield Corporate Bond ETF). The Index dropped by 57.8% to 922 from its record high of 2,182 on December 15, meaning the spread between high-yield debt and comparable US Treasuries was 922 basis points on Friday. Considerable progress has been made and high-yield spreads “only” need to fall another 7.4% to reach the “pre-Lehman” level (854 basis points).

The quote du jour this week comes from Richard Russell (Dow Theory Letters) who said: “I’m reading and listening to an awful lot of drivel these days. Every analyst has his own scenario, and all seem anxious to broadcast their personal opinions. In this business, there comes a time when the situation is so complex that the most honest thing to do is simply to admit that you don’t know what the hell is going on. The best thing to do is to keep your mouth shut and await developments.” (Also read Barry Ritholtz’s related post on “Analyzing the analyzers“.)

Other news is that Washington hosted a US-China Strategic Dialogue, as the Chinese are increasingly focusing on America’s deficit, the value of the US dollar and the implications for their Treasury holdings. Interestingly, the Federal Reserve’s balance sheet last week contracted for the second consecutive week. “Do you think Ben assured Chinese officials earlier this week that the Fed was reducing its balance sheet?” asked Bill King (The King Report).

Also, the US House of Representatives on Friday approved a $2 billion extension of the government’s car sales incentive program, “Cash for Clunkers”, while the Federal Deposit Insurance Corp (FDIC) closed four more banks on Friday, bringing the tally of US bank failures in 2009 to 68 (93 since the beginning of the recession).

Next, a tag cloud of all the articles I read during the past week. This is a way of visualizing word frequencies at a glance. Key words such as “bank”, “economic”, “market”, “prices”, “growth”, “China” and “Fed” featured prominently.

The key moving-average levels for the major US indices, the BRIC countries and South Africa (from where I am writing this post) are given in the table below. All the indices trade above their respective 50- and 200-day moving averages. The 50-day lines are also in all instances above the 200-day lines and therefore not threatening the bullish “golden crosses” established when the 50-day averages broke upwards through the 200-day averages.

Importantly, the 200-day moving average of the S&P 500 Index last week turned up for the first time since January 2008, after being breached upwards by the Index in early June. The 200-day line - generally seen as a key indicator distinguishing between a primary bull and bear market - is now trending higher for all the indices included in the table, with the exception of the Dow Jones Transportation Index and the Russian Trading System Index.

The June highs and July lows are also given in the table as these levels define a support area for a number of the indices.

When considering monthly data, three momentum-type oscillators (RSI, MACD and ROC) are reversing course for the first time since the sell signals of 2007 and now either indicate buy signals (or are getting close to one in the case of MACD).

The bulk of the Q2 earnings reports in the US are now in and 71% of the companies have so far reported better-than-expected earnings - one of the highest quarterly readings over the last ten years and by far the highest since the bear market began in late 2007 (albeit largely as a result of cost cutting negating a decline in revenues). “We’ve now had two straight quarters where the ‘beat’ rate has increased quarter over quarter, meaning analysts overestimated earnings to the downside. This is a very positive sign for the market at the moment … ,” said Bespoke.

Expectations for the next earnings season will be high and whether these are met will be determined by the extent of the economic recovery. “… what should matter most for stocks is nominal GDP - price multiplied by volume. Indeed, the chart below illustrates the case - the rate of change in the S&P 500 ultimately tracks the trend-line in nominal GDP growth,” said David Rosenberg.

I now know why I keep thinking of those ELO lyrics - it’s the stretched valuations that bother me. Based on operating earnings (i.e. stripping out everything that is bad), the historical price/earnings (PE) multiple of the S&P 500 is 24.6; using reported earnings the figure shoots up to a giddy 777.5! Getting past the loss-making fourth quarter of 2008 and calculating prospective multiples through December 31, 2010, reduces the valuations to 17.8 and 32.9 respectively - still hardly the type of valuations that will inspire one to be a buyer across the board. (The earnings estimates are courtesy of Standard & Poor’s.)

Kevin Lane (Fusion IQ) said: “We have been saying for a while now that the market would likely work higher as sentiment was more doubting than embracing, suggesting that many still had not deployed a lot of capital. That said, we now believe that investors who let the market run away from them or were only partially invested are finally coming into the pool. The new entrants could certainly fuel things (i.e. new buying power) a little bit further before we have another corrective wave. That said, we think in the not too distant future and a bit higher from these levels there will be an opportunity to make sales before a late summer/fall correction.”

Looking at the next few weeks, I am of the opinion that stock markets have run away from fundamental reality and that a pullback/consolidation looks likely. Taking a slightly longer-term view, I think we are in a (possibly lengthy) bottoming-out phase as far as slow-growth (OECD) countries are concerned, but already in new (potentially volatile) uptrends regarding high-growth emerging and commodities-related markets.

Economy
The results of last week’s Survey of Business Confidence of the World achieved their best level since early October, reported Moody’s Economy.com. Business sentiment is improving across the globe and businesses’ broad assessments of current conditions and the outlook into 2010 have brightened meaningfully. However, despite the steady improvement in confidence, businesses are still cautious and the Survey results remain consistent with a global economy that is still in recession.

According to the European Central Bank’s Q2 2009 bank lending survey, the number of banks tightening standards is falling across all loan types. “If you asked me, this constitutes good(ish) news. The credit crisis in Europe has likely passed …,” said Rebecca Wilder (News N Economics).

A snapshot of the week’s US economic reports is provided below. (Click on the dates to see Northern Trust’s assessment of the various data releases.)

Thursday,July 30, 2009
• Jobless Claims report makes a case that the labor market is improving

Wednesday, July 29, 2009
• Durable Goods Orders - decline in airline and defense masks improvement

Tuesday, July 28, 2009
• Case-Shiller Home Price Index - home prices are stabilizing
• Consumer Confidence Index slips in July

Monday, July 27, 2009
• Sales of new homes surge in June, inventories of unsold homes are sliding down

Additionally, the Federal Reserve’s latest Beige Book, released on Wednesday, indicated that the US economic recession was becoming less severe. While still weak, some regions reported that the pace of the downturn had moderated.

According to the US Commerce Department’s advance growth estimate, real GDP contracted at an annualized rate of 1% in the second quarter - smaller than the consensus expectation for a 1.5% decline. The rate of contraction slowed from the first quarter’s -6.4% as a result of a much smaller decline in investment, a smaller drop in inventories, less of a decline in exports, and strong government “stimulus” spending (+13.3% on an annualized basis - see chart below). However, consumer spending fell by a disappointing 1.2% in the second quarter.

Summarizing the growth data, Paul Kasriel (Northern Trust) said: ” … the worst is over, but the best is not yet at hand. The imminent recovery will take hold not with some sustainable explosion in one sector or another, but because some hitherto really weak sectors will stabilize and/or grow a little.”

“We expect a gradual recovery in the US economy in the months ahead, but the Fed will need to keep the policy setting extremely aggressive to achieve a self-reinforcing upturn in consumer confidence and spending,” added BCA Research.

Warning of a W-shaped recession, Nouriel Roubini (RGE Monitor) said (via Forbes): “The global recession may end toward the end of 2009 - instead of sooner - but the global recovery in 2010 will be anemic and well below trend as households, firms and financial institutions are constrained in their ability to borrow, lend and spend.

“Meanwhile, a perfect storm of the following has inched a little closer on the radar of this cloudy global economic outlook: persistently large fiscal deficits and public debt accumulation; monetization of such deficits that will eventually increase expected inflation; rising government bond yields; soaring oil prices; weak profits; still-falling job figures; and stagnant growth. It’s a storm that could blow the recovering world economy back into a double-dip recession by late 2010 or 2011.”

Week’s economic reports
Click here for the week’s economy in pictures, courtesy of Jake of EconomPic Data.

Date	Time (ET)	Statistic	For	Actual	Briefing Forecast	Market Expects	Prior
Jul 27	10:00 AM	New Home Sales	Jun	384K	355K	352K	346K
Jul 28	9:00 AM	S&P/Case-Shiller Home Price Index	May	-17.06%	NA	-17.90%	-18.10%
Jul 28	10:00 AM	Consumer Confidence	Jul	46.6	49.0	49.0	49.3
Jul 29	8:30 AM	Durable Orders	Jun	-2.5%	-0.7%	-0.6%	1.3%
Jul 29	8:30 AM	Durables, Ex Transportation	Jun	1.1%	0.0%	0.0%	0.8%
Jul 29	10:30 AM	Crude Inventories	07/24	+5.15M	NA	NA	-1.80M
Jul 29	2:00 PM	Fed’s Beige Book	-	-	-	-	-
Jul 30	8:30 AM	Initial Claims	07/25	584K	560K	575K	559K
Jul 31	8:30 AM	GDP-Adv.	Q2	-1.0%	-1.5%	-1.5%	-6.4%
Jul 31	8:30 AM	Core PCE	Q2	2.0%	2.3%	2.3%	1.1%
Jul 31	8:30 AM	Chain Deflator-Adv.	Q2	0.2%	1.1%	1.0%	1.9%
Jul 31	8:30 AM	Employment Cost Index	Q2	0.4%	0.3%	0.3%	0.3%
Jul 31	9:45 AM	Chicago PMI	Jul	43.4	42.0	43.0	39.9

Click here for a summary of Wells Fargo Securities’ weekly economic and financial commentary.

Across the pond, the Bank of England (BoE) and the European Central Bank (ECB) will make interest rate announcements on Thursday (August 6), while in the US economic highlights for the week include the following:

Markets
The performance chart obtained from the Wall Street Journal Online shows how different global financial markets performed during the past week.

“It’s not whether you’re right or wrong that’s important, but how much money you make when you’re right, and how much you lose when you’re wrong,” said George Soros. Let’s hope the news items and quotes from market commentators included in the “Words from the Wise” review will assist Investment Postcards readers in adding considerable value to their balance sheets.

That’s the way it looks from Cape Town (where the sun is making the winter days very pleasant).

* Dr Prieur du Plessis is chairman of Plexus Asset Management and writes the Investment Postcards from Cape Town blog (www.investmentpostcards.com)