Negative Fatigue (or, The Power of Asset Allocation Rebalancing)
We start off the New Year with no shortage of adjectives to describe the month in markets that was January. While it remains unclear how broad the participation has been and to what degree the strength is sustainable, there is no question that investors, helped by the world’s central banks, moved out on the risk curve to produce a very impressive run across almost all asset classes.
This month we need to look over three issues:
– Shrinking Profit Margins
– Rolling over debt
– Election Cycles
The reason we are focusing on margins is because they are at historically high levels and we are wondering a) how long they can stay there and b) if they can’t what it means for equity and bond valuations going forward. Second we look out to the roll over of close to 1 trillion Euros this spring – with a big chunk of that coming from Spain and Italy – Ay Caramba & Mama Mia! Finally, as we enter the election year I wanted to revisit an old barometer of return that we look at year in and year out.
While global bond markets took a well deserved pause, equity markets picked up the slack clocking one of their best Januarys since the mid 1980s. Incidentally that’s when the credit bubble, that caused the mess we are in, took root.
At any rate the power of the index led rally was not to be ignored. Better than expected data at the beginning of the month combined with the traditional beginning of year asset RE-allocating and that was all the fuel markets needed to complete one of the best six week periods in the history of equity markets.
Incredible Disappearing Margins
At Strategic we watch a number of indicators to help us understand where one is most at risk and where one might be best positioned both in terms of offense and defense. Investors have learned in recent years its helps to be good on both sides of the line.
To that end we review data sets like weekly tax receipts, slated public and private building projects and of course the old corporate margin or two. Something that we noticed as we begin earnings season mid-month was that margins seem to have not only topped out but they seem to be shrinking dramatically depending on the sector one puts under the microscope.
Our first two charts this month – courtesy of our pals at Goldman Sachs show us that as of the end of the month we are witnessing a topping out of the margins and margin expansion. While there are some sector eccentricities its worth understanding that elevated levels of margin and or continuous growth in margin expansion in mature companies – like those that make up the S&P 500 are very rare periods of history indeed.
Our second illustration shows us that Q4 earnings are tailing off from Q2 and Q3 upside surprises to a more normalized rate of earnings distributions. One of the eccentricities that we like to point out is that capitalization weighted indexes can have very peculiar behavior when only a handful and in more recent times only one of its constituents performs well.
This month’s spotlight then falls on the tech darling of the last decade – Apple. The stunning earnings growth reported by the company formerly lead by Steve Jobs was nothing short of jaw-dropping.
Even with the boost from Apple, the blended (reported & estimated) aggregate Q4 earnings growth rate for the S&P 500 remains well below the 15.0% level computed in early October 2011. Two of the biggest contributors to this decrease are the Materials and Financial sectors. The Materials sector growth rate dropped from 25.6% to 10.4%. This drop is primarily driven by Alcoa’s 114% plunge in net income. Additionally, most commodity prices (with the exception of copper) continued to fall in response to macroeconomic news and seasonal trends.
The point here is to look under the covers and make sure you know what you are paying for as investors.
Rolling it Over
“Don’t worry, she’ll hold together… You hear me, baby? Hold together!”
―Han Solo, talking about the Millennium Falcon
Why is it that the current debt rollover situation seems eerily like the moment quoted above in Start Wars? One has the distinct feeling week after week that the brash and uncalculating Merkozy has no idea if the coming rollers in the Spring of this year will impale the Euro and the Eurozone once and for all.
We happen to think that it will not but the reason for why and what the market consequences are produce a very different outcome for investors based on how one is positioned.
If the EU can get this year rolled over and “muddled through” then the balance of the world stands a chance of making it through 2012 whole. Given what we’ve seen out of Europe in the post 08/09 environment we think it wise to be ready to any turbulence that may be unforeseen – Millennium Falcon not withstanding!
As we finalized our January copy there are rumblings of a “final deal” on the Greek situation. We wondered aloud in 2008/09 about the kind of moral hazard that saving the banks would produce only to witness the “reality distortion field” of 2011 produce bizarre correlations, promises and fantasies.
Unfortunately there will be fewer fantasies this time around and we now wonder allowed if the other Sovereigns will balk at paying par back when its time to roll over their paper. This is a very dangerous precedent to set if we see a writedown without default.
As many before have said in various iterations – Capitalism without failure isn’t capitalism.
Cyclical – This time it’s Elections
For the past two notes I have threatened to talk about Presidential Cycle returns. I made mention of this phenomenon last year at this time when we predicted a low return year for equities. Our prediction was based on lower GDP growth rates but also in part to the notion that over a four year rolling period one tends to see a normalized distribution of returns numbers – ON AVERAGE.
To us the fact that investors thought that they would be entitled to the rather high level of customary “third year” returns was incongruous to us with the fact that much of their desired return had already been provided to them in years 1 and 2 of the current administration. Who you credit with those returns is your own business – all we know is that distributions of returns normalize and so to us it made sense that we had already borrowed forward a number of those pieces.
And so it is that we think we have borrowed a good deal already this year. Having seen the same pattern emerge for the last three years reminds us that the rise in January is nothing new. Taking chips of the table looks to be a prudent move. Staying defensive while there remains a lack of clarity may also be reason enough to step to the side.
Last year it was Fukushima that broke the market’s back. This year we suspect it will be something equally unanticipated. And for those reasons, we choose to anticipate.
One Response to “Negative Fatigue (or, The Power of Asset Allocation Rebalancing)”
hold together….this is your conclution …ok i live in earth not in march..thank you