Thursday, 24 January 2013

GLOBAL ECONOMY (January 24th 2013): Update of Analysis, US Data, China PMI, Europe, Japan

Today we'll be providing some update on previous assertions and calls on the US, China, Europe and Japan, along with any new insights derived with new data since our previous articles were posted.


From our article on December 3rd:

China has shown more convincing evidence that business conditions have stopped deteriorating, allowing for hope that we can count on China in 2013 for stable growth. While the recovery in data is fragile, at a nine month high, we're more convinced than before that the Chinese economy has "stopped slowing"...

... Presently, the Shanghai (SSEC) equity market index sits on a price to current (2012) earnings ratio of around 10.7 . If as an investor you are bullish on China's long term prospects, and you feel that 2012's earnings are a safe, conservative level to rely upon, then this may be a fine opportunity to add long term holdings. Shorter term traders may have to time their entry to their preferred method - it takes some bravery to add exposure near bear market lows...

... This should not constitute a blind buy recommendation for stocks in that region - that is only one of many ways a trader or investor might approach this move towards improving business conditions in China. For one, our overall global macroeconomic outlook looks far brighter without China "slowing down".

Longer term investors meanwhile may want to investigate possibilities in stocks with Chinese exposure, or more directly through China investment funds. While we cannot be certain that conditions in China are "bottoming", we know that on a 10.7 multiple of 2012 earnings, long term China bulls could enjoy a relative margin of safety so long as 7-10 year growth in Chinese earnings is at least modest, compared to 2012 levels.

Two important data points have since been released from HSBC China Manufacturing PMI, further confirming our recommendations and analysis with readings of 51.5 and 51.9. In the interim period, the SSEC average current earnings multiple has increased to 12.5, reflecting the remarkable 19% rally in Chinese equities since our call on the 3rd.

We will rarely make similar calls, and the short term favourable timing was coincidental, rather than any unusual technical insight - although the call did come within hours of the bottom in Chinese equities, it could have come weeks before, or months afterwards.

As an update to the original analysis, short term traders will again want to assess the technical implications of entering the market after such a spectacular run. For buy and hold investors, insight has to be made on a few parts:

1) Whether you believe current earnings of the average Chinese enterprise are "normal", rather than overblown or depressed. In either case, you need to make a conservative estimate of this, and "normalise" current earnings accordingly. If you believe they are depressed, avoid normalising, and allow the difference to be absorbed in your margin of safety. If you don't believe that the current earnings can be "believed" on a whole for Chinese stocks, avoid making any investment decision in the region.

2) Whether you believe business conditions really have bottomed. Our analysis is suggesting to us that this is the case, and has been the case since November/December. The strength of the trend in leading indicators has been helpful in proving that case for us, you need to reason with yourself whether or not you believe this is so, and hold conviction in that belief. If you hold no opinion on whether conditions have bottomed, then you may want to avoid market timing altogether and look purely at the valuation aspect.

3) Whether you believe long term growth prospects in China, and in Chinese corporate earnings and capitalisations, are suitably high relative to the current multiple placed on those normalised earnings. If we accept the average multiple of 12.5 on Shanghai stocks, relative to around 17 on the S&P, and a total P/E of 16 for the EuroStoxx 50, you need to then decide whether growth prospects of Chinese corporate earnings are appropriate relative to the capitalisation of current earnings.

In our own analysis of these factors, while we might not be comfortable on the timing of further gains, we still believe there are significant opportunities in Chinese funds and indices for long term investment. We maintain the key points of our original analysis, and while the "trade" has become suddenly quite crowded, the benefits to the global economy and the investment prospect remain the same as our analysis reprinted above.


Also from our article on December 3rd:

If the Yen "needs" to devalue, is there an opportunity in the currency markets against the dollar? ...

The deterioration of Japanese business conditions continued again this month, an under-reported concern for the global economy. Most worrying perhaps is the suggestion that a complete lack of demand and business confidence has reduced capital investment this year, further compounding the problem.

Rather like in the UK's indicators, we find it difficult to apply this kind of analysis to the Japanese stock market - for instance, by short-selling the NIKKEI. Instead, we wonder what currency implications might be for the Yen - already almost 5% devalued against the dollar since November's high. If this bearish trend [in business conditions] continues, where will the Yen be against the dollar several months from now? ...

The problems in Japan may stretch further than a currency problem, but a more competitive Yen would surely improve the prospects of Japanese manufacturers. A trader with experience in Forex may wish to evaluate the possibilities of even further declines in the Yen against currencies in more competitive regions.

While calling for a further devaluation of the Yen was far less a controversial suggestion in December than the one above, it was nevertheless supported by an analysis of the leading indicators in Japan. The move from 0.81c to 0.90c represents an 11% move since the article. Is it still justified?

It's difficult to say what intrinsic level currency pairs should find themselves at, and a technically minded Forex specialist might do better to answer the question. However, from a fundamental view, the latest Japanese PMI reading reflects yet another dreadful month (from 46.5 down to 45.0 now) - and quite rightly policy makers have been forced into powerful rhetoric.

We believe that further devaluation is necessary, that it is warranted by the abysmal current indicators for business conditions, and that Japanese policy makers have the power to make good on that promise. Our analysis of the trends remains the same as previous months - even if we'd struggle to place short term forecasts on how the market will behave. As a longer term call, we believe that we'll see further weakness in Yen relative to more competitive currencies, something exacerbated by current deteriorating business conditions in the region.


Also from our December report:

[On Eurozone Composite] We can see that conditions remain at depressed levels, but can take encouragement in the signs of improvement since the summer. Last month's setback was a worrying sign for global markets, given the accuracy of Eurozone PMI in predicting market trends. Hitting an eight month high this month, we hope the data continues to improve more convincingly into 2013.

[On Germany] While the German manufacturing sector remains in contraction, the present data suggests a mild trend of improvement, that will hopefully see the sector return to expansion in 2013. Unquestionably, in the December report released early next year, we will want to see a reading closer to 48.0 for proof that the trend is not stalling. Supporting this, new orders and production components of this month's report stabilised close to 50, for the first time in several months.

[On France] Worryingly, this month reports that output had fallen in response to falling new orders, and much production came as a result of the devouring of backlogs of work, at a pace unchanged from October. The commentary suggests a lack of domestic demand, and the retrenchment of French manufacturing on a whole, responding to the expectation of weak demand for the foreseeable future.
We'll be more convinced of a recovery in French business conditions if the data significantly improves into 2013. Until then, we're not entirely sold on the French economy.

These three main trends seem to have played out with some accuracy. True to form, the French data deteriorated to a 46 month low of 42.9. The German data improved to 48.8, indicating that indeed we can be more convinced of the trend of improvement in German business conditions. The Eurozone Composite indicator hit a ten month high, continuing to move in the direction of expansion.

These kinds of trends are susceptible to change, but are important to understand, even if we don't derive trading or investment ideas from the analysis. On a whole, the signs are more encouraging for global growth in 2013 from this particular component.



From our latest piece earlier this month:

In summary of US business conditions, and the outlook for earnings and economic growth, we really need to see improvements on 2012 in the following forms: less uncertainty over US politics and aspects of the tax code; a continued improvement in the US construction sector; a return to normal activity for the Manufacturing sector; continued improvement in the number of jobs added to the private sector; continuation of subdued cost-pressure on US businesses; positive effects of monetary policy filtering into business activity; and any signs of pent-up activity after the uncertainty in late 2012 translating into higher 2013 growth...

Bullishness on US business conditions, and thus corporate earnings for 2013 will hinge on the above factors producing a net improvement on 2012......So understandably, we're concerned about the rate at which corporate earnings and GDP will grow in 2013 while the US manufacturing sector remains in a slump. This is less down to the economics of the sector itself, but the leading "bellwether" qualities of the manufacturing indicators...

At the very least, we'll want to see capacity utilization stabilise around the level of its 2012 79.2% peak, without substantially falling back to 2011 levels.

While we've seen few new data points released since then, we reiterate that ideally we'll want to see business conditions improving for corporate earnings growth to continue in 2013, having stalled through much of 2012.

Another positive US Markit Manufacturing PMI report today could be significant (up to 56.1 from 54.0), and we await confirmation of this improvement in the ISM figures. Two good weeks of Unemployment Claims in the 330k region, while a volatile indicator, might be an early reflection of an improvement in US employment conditions. The positive trend remains in place for ISM Non-Manufacturing. Capacity Utilization, released last week, shows a second month of improvement up to 78.8% - although we'll want to see this indicator staying around the 80% level throughout 2013.

[On the trend in Housing recovery]
We expect that if this trend continues throughout 2013, the effects are likely to filter through into the wider US economy, in terms of job creation, consumer spending and financing activity (creating opportunities within the mortgage sector in 2013, something that Jamie Dimon noted as improving in JP Morgan's latest results). Earnings growth could easily come at a rapid pace in sectors with cyclical exposure to the housing industry because they come from a depressed base - but this does rely on continued improvement in the construction sector.

Earnings season is well underway, and so far signs have been encouraging in these sectors. Record results at Wells Fargo underpin this analysis, and while we find it hard to quantify the rate at which earnings will increase in the housing and financial sectors, we must consider this in our expectations for overall US earnings growth in 2013. While business conditions remain sluggish elsewhere in the US economy, earnings growth could easily be driven by these previously depressed sectors.

In terms of the forward-looking Housing Data itself, while still clearly in a broad trend of recovery, little progress was really made in the latest numbers, with Building Permits unchanged at 0.9M. We'll want to see more convincing improvements as 2013 progresses, but we continue with our assertion that we've already seen the bottom in US Housing.

[On adding long term investments at the current market level]
In summary of these factors, relatively expensive valuations are currently being placed on US stocks compared to historical standards, although valuations are far from extraordinary. This does not imply stock prices are too high - so long as they are justified by realistic expectations of corporate earnings and GDP growth. We must also consider that interest rates are very low - and can be expected to remain so for at least a few more years, making stocks "worth" the higher prices in the near-term.

With that in mind, we have relatively little interest in adding long term investments in average US stocks that reflect this valuation. Stocks on a whole are at least in the range of fair value, so any investment must be on the basis that earnings and GDP growth will be considerably better than expected over the next several years. The basis by which we can realistically expect this in the short term, is presented above in our analysis of ongoing trends in business conditions. 
The room for capital growth in the average US stock meanwhile, must otherwise rely on stock prices outstripping the rate of increase in underlying earnings - something we fail to see as an attractive option. We'll meanwhile be cautiously limiting ourselves to conservatively priced opportunities with any new funds, knowing the risk priced into the current market level.

With the S&P having climbed another 2% higher since that article, we're more emboldened in our belief that value is hard to come by in the average US stock at this time. The expected long run return we'd expect from current market prices is not great. Therefore, we maintain that we do not advocate simple buy-and-hold strategies of the S&P here, unless we expect corporate earnings to rapidly expand markedly over the coming years. Either way, for long term investment, there isn't much of a margin of safety at the current price level. We urge long term investors to be patient, to avoid "chasing" prices, and to be highly selective in their purchase of equities.

While we cater for investors in our analysis, we also offer insight for traders, as we did in our previous article:

... BPNYA indicator from is perhaps our favourite market breadth indicator, measuring the % of NYSE stocks that are showing a bullish P&F pattern. Protracted periods above the 70% level tend to be associated with new bull market highs, and a general "overdone" momentum in stocks. At this stage of such a rally, in BPNYA terms we recognise that the market is in a particularly "bullish mood", and that stocks on average are likely to overextend themselves with momentum.

These conditions are normally good for "letting trades run", maybe with a trailing stop order, in recognition that the trend could abruptly end at any time. Using BPNYA, instead of second-guessing the Dow's movement to determine that trend, will likely provide less volatile (and less stressful) returns. Until the BPNYA indicators comes crashing down (you usually then get a chance to sell near the top), we can be relatively comfortable in letting momentum trades run.Most importantly - avoid getting carried away with current S&P price levels. As per the analysis above, business conditions and corporate earnings will need to improve substantially to support current S&P estimates. The current S&P and Dow levels are bound to be overblown with the BPNYA indicator in such a bullish mood - don't be surprised if we see the S&P back to 2012 levels in later months.

From a trading point of view, valuation aspects only need a cursory glance, and few of our trader readers will have any need to concern themselves with ten year Shiller PEs and the like. Instead, when considering ideas from a trading point of view, we advocate the use of some simple market breadth indicators to assist in determining the market's "mood".

Finding fertile periods for trading can be extremely helpful in avoiding trading during choppy markets. Here is how that BPNYA indicator is looking:

Note that it remains embedded above the 70% mark having troughed in November. We make no changes to our above recommendation that momentum trades can be left to run with a trailing stop, especially if risk assets were bought on oversold conditions in November as advocated.

However, be aware that the party always comes to an end, and that you cannot afford to be at the ball after the clock strikes midnight. Be cautious and don't allow yourself to be carried away, something we're reiterating from our previous article.

The S&P Daily chart has already reached Overbought conditions. 1500 might be a level that the market struggles with throughout 2013... although we're far from keen on guessing where momentum will take the market. The use of trailing stops takes some of the emotion out of that decision, but some gentle profit taking would be wise around these levels.

We think it's still likely that we'll revisit some of the levels seen in 2012 at some point this year. So as an additional warning for less experienced traders or investors - don't expect market conditions to remain as buoyant as this indefinitely.

Enjoy it while it lasts, and be prepared to take a different approach when conditions and market sentiment inevitably change.

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