David Rosenberg, formally of Merrill Lynch, recently became Chief Economist & Strategist at Gluskin Sheff + Associates Inc., a
Rosenberg’s 6/2 letter, while a few days old, has some great pieces of information for those willing to take the time to read it. Highlights from the article are below:
“Emerging markets in general can hardly be described as cheap as they trade at 43x earnings, but nothing really stands out as being undervalued right now. The S&P 500 has gone ahead, in our view, and priced in an earnings profile we don’t see occurring for another three years — at the earliest. As everyone gazes at the 200-day moving average being taken out for the first time in 18 months, we are still wondering (see below) what the omen was yesterday from the fact that the VIX index, for the first time in at least seven years, rose alongside a 2%+ performance in the S&P 500 (normally, the VIX index declines between 10% and 20% on such a rally).
Bonds are still trading quite defensively, and the yield on the 10-year T-note has managed to do in less than six months, which is to soar 170 basis points, what it took 48 months to do in the last bear market in bonds (June/03 to June/07). Inflation expectations are getting way ahead of themselves — the 5-year/5-year breakeven levels in the TIPS market are now at 2.4% (above the average of the past five years — you would think we’d be staring at a fully employed economy right in the face). This is at a time when both the YoY trends in the CPI and PPI are negative to boot, not to mention the highest underlying jobless rate and lowest industry CAPU rates in modern history! Talk about a new paradigm. The U.K. gets its credit outlook downgraded, and its currency soars and its bond market vastly outperforms Treasuries. Welcome to silly season. The 2s-10s curve is back at 275bps, a record steepness, and never before has a curve this steep been sustainable — it will flatten, the question is how.
The futures market, without perhaps understanding what history teaches us about the stance of monetary policy following a credit collapse, which is to keep rates to the floor for, oh, about a decade, has gone ahead and priced in no fewer than three Fed rate hikes over the next 12 months. Then again, it’s the same futures strip that started to price out the easing cycle in late 2007 and price in Fed tightening this time last year. This is what opportunities are made of. We still expect to see long-dated yields enjoy a significant second-half recovery once it becomes evident — likely later this summer — that there is no durable recovery starting in the third quarter.
As an aside, from our lens, part of the run-up in Treasury yields may be related to the shift to risky assets, perhaps related as well to exuberance over some of the economic data and hopes the recession will end. Though we did see yields bottom in 1993 and again in 2003, long after recessions ended, so the contours of the recovery are also very important in the interest rate outlook — bond yields never hit their bottom until after the unemployment rate peaks, and that is likely at least a year away, in our view. But there are technical factors at play too, which is mortgage-related selling (mortgage investors move to offset their duration exposure when rates back up by selling Treasuries — this last happened in a situation like this in the summer of 2007 and it ushered in one of the most fantastic buying opportunities in years at the long end of the curve). Those pundits calling for higher yield activity seem more bent on following the market than calling it.”
Later in the letter, he notes that investors should focus on bonds and dividend paying stocks with strong cash flow:
“The global trailing P/E multiple has surged five points during this rally to 15x. So this market is far from cheap. Let’s look at the S&P 500. A classic mid-cycle multiple is 15x, so basically the market is pricing in $63 of operating earnings. That is being generous because based on where the corporate bond market is trading, the fair-value multiple is around 12.5x, which then means that equities are discounting $75 of earnings, which we would not expect to see until 2013 at the earliest. (A 15x multiple is also rather generous when one considers that we now have an economy where large chunks — autos, insurance, mortgages, banks — are at least partially owned by the government.) Look at this way — we are going to be hard-pressed to see operating EPS much better than $43 this year. A ‘normal’ first-year earnings bounce is 20%, and again this is being generous, but that would leave us with $52 EPS for 2010.
We give that prospect very little chance of occurring, and we have some difficulty with the stock market going ahead and pricing in an earnings profile that is likely four or more years away from occurring. Are we going to be back pricing in end-of-cycle or recession earnings this time next year at the rate at which investors are discounting the future….
….We are not as bearish on the stock market, at least over the short-term, with the S&P 500 breaking its 200-day moving average. As we said, there is the risk of a melt-up as portfolio managers play catch-up. After seeing housing starts collapse 13%, core capex orders slide 1.5% for two months in a row, jobless claims pierce the 600k mark for an unprecedented 17 weeks in a row, organic personal income drop for eight months running and back-to-back declines in retail sales with little sign of a turnaround in the weekly May data-flow, it stands to reason that this is an equity market that is extremely forgiving and resolute in its belief that the recession will give way towards sustainable positive growth starting next quarter. We say this with the utmost of humility, but the onus, indeed the pressure, is now squarely on the bears….
….However, long-term, we believe that the U.S. economy is in a gigantic mess and that risk-taking in the stock market is not going to be rewarded on a sustained basis. We continue to hold the view that the stock market, which peaked in 2007 just two months shy of the most intense recession in 70 years, is vastly overrated as a forecasting device and we strongly believe that portfolios will need to be cash-generating machines.
If the portfolio isn’t providing steady income, the return for investors is going to be extremely minimal or even negative. So obviously bonds will be playing a huge role — Treasuries and Canadas at current levels offer a significant inflation-adjusted yields and high-grade corporates still look attractive despite the ongoing compression in spreads. Within equities, we hold to the view that investors should focus on strong dividend-payers and stable cash flows.”