Market Thoughts

Sean Pignatelli Institutional Equity Sales (+44) 20 7071 7533 Thursday, August 25, 2011

Its been an interesting time to be away... Most of the messages I received were regarding Jackson Hole (will he or wont he?). Little focus seemed to be on Europe and there was virtual none on the market! Ill largely skip the Jackson Hole debate for the momentum, mainly because there really isnt a debate. Bernanke will not launch QE3 because he cannot launch QE3. He may indicate other policy options, such as lengthening the duration of the Feds bond holdings, but that was summed up well by Jon Hilsenrath (of the WSJ), as tweaking. I actually believe it could end up being quite an effective policy tool but try telling that to the tribes of risk on junkies expecting their next fix. Jackson Hole is surely setting up as a disappointment. As I see it, the more interesting questions here are: 1/ Are we heading for recession? 2/ What are we pricing in? 3/ Is this a Correction or Bear Market? The first answer is easy. If were not heading for recession its because were already in one! Both the market and data appear to be confirming as much, however, I would just use common sense. Having barely grown for the past 2 quarters, the economy has accelerated to the downside. The close bond to confidence that this cycle bears (common in any deflationary period but exacerbated by the recent crisis) ensures that economic momentum will continue to decelerate over the next couple of quarters, at least. The pathetic reduction in 2H GDP estimates from 3% to 2.5%, or even 2.0%, illustrates the level of denial that is still in place. The second answer is only slightly trickier. I started hearing "we're pricing in recession" after just a few percentage points decline, but I seriously doubt

Source: Bloomberg Finance LP

that Again, common sense (and experience) should tell us that markets (and/or stocks) do not bottom until the symptoms have been correctly diagnosed. Until we accept that we are in a recession we will not discount one. We may bottom at the very first realization but, again, we appear to be some way off from that realization just yet. A more scientific approach can be seen below, comparing the historical performance of defensive vs. cyclical sectors. I've removed anything that may distort things, which means I am only comparing Staples & Health to Industrials & Discretionary. Obviously the Financials and the resource sectors were distorting recent events, but Tech caused even more distortions last cycle, so all have been removed. For balance, I have then just compared the remaining two cyclical sectors against the two most obvious defensives, Staples & Health (as both Telco and Utilities became entwined in the respective bubbles at the time).

A quick glance tells you all you need to know. Firstly, if we are heading into a recession, then the relative outperformance from defensive sectors has only just started. Secondly, far from leading, there is actually a decent lag. Note that defensive relative performance only rolled over in Dec 91, Oct 98, Mar 03 and Mar 09 - so not exactly at the onset of recessions! Finally, are we in a Bear Market? Not quite but if we don't rally sharply, and soon, then we will be shortly. Never mind the totally spurious definition of
Source: Bloomberg Finance LP

down 20%, a Bear Market is one which is trading below both its medium and long term trends, and where both of those trends are negative. As long as a market remains below these two trends then there can be little question that it is in Bear Market territory. As you can see below, since 1982 this has only occurred twice, in 2001 and 2008.

It is therefore more than a little worrying that we are hovering so close to this inflection point now. Even more concerning is the fact that many of the key markets around the world, such as Euro Stoxx, China, Brazil, and now India, are already there... In fact the US is in Bear Market territory when adjusted to Trade Weighted Dollars.

Another indicator that tends to deteriorate quite some time before a major low is New Lows. As you can see, the recent reading is a complete trend
Source: Bloomberg Finance LP

smasher - blasting out the mid 07-08 levels, and only ever bested in Oct-Nov 08. This reading alone would have me believe we've entered a Bear Market.

I do try to maintain a positive outlook, largely because its always easier to find fault in things than it is the see the good (particularly when attempting to see into the future), but unexpected positives do occur, along with the expected negatives. Similarly, I keep the bar for being short extremely high, as of course markets do go up over time. However, it is starting to look like too many mistakes have been made now (and not just in the US). I see absolutely no reason to change stance here on sectors and style, with a strong emphasis on high quality and aggressive underweight in commodity related and other reflation plays. On my last note (Man or Mouse, 11 Aug), I received surprisingly strong and completely one-way negative feedback on my view that quality could outperform even if equities rallied. We havent rallied much (given the scale of the decline) but the S&P is up just over 5% since then (though I wasnt really trying to make a market call). The interesting thing is that the 4 defensive sectors have led the rally, with Utilities top (+9.5%), Healthcare second (+8%), Staples third (+7.1%) and Telco fourth (+6.75%). Perhaps even more surprising is that the small caps (Russell 2000), having been absolutely crushed on the decline, actually underperformed the mega caps of the S&P 100 on the bounce The best cyclical sector was Consumer Discretionary (+5.7%) but all the others underperformed. If we continue to rally then clearly cyclical sectors should start to act better, but Im beginning to doubt that were off to the races just
Source: Bloomberg Finance LP

yet. In any case, I would still expect Discretionary to be the best performing cyclical sector. In terms of the market, we may rally a bit more into Jackson Hole but Id expect a pullback then, possibly taking out the recent lows. This is of course predicated on my view that Bernanke is not in a position to deliver on QE3. Again, portfolio rebalancing can probably be quite effective, but even Bernanke will have trouble packaging that one well for the current audience. I understand the very good macro team around at Barclays has calculated that $500bil of asset purchases is now being priced in, and QE3 is the new base case at GS (another firm with a decent record on Fed maneuverings). However, perhaps the best (certainly the simplest) way to measure the QE3 hype is through the EUR-USD rate. This has correlated absolutely perfectly with the yield differential between Europe and the US (on 5yr Gov bonds). As you can see below, a huge divergence has emerged in the run up to Jackson Hole. I would therefore expect a great deal of disappointment on Friday, even though QE3 would unquestionably be a catastrophic policy if launched whilst inflationary pressures are present.

More likely, Bernanke will look to shift the burden onto the Administration. Given pathetic recent displays, from both parties, its hard to believe that

Source: Bloomberg Finance LP

this will get the markets juices flowing. However, there are murmurings that a restructuring of the Refinancing rules may be on the cards, and that would certainly have a positive impact. Again, the biggest beneficiary would probably be Discretionary as, in effect, it would be a tax cut but one funded by an increase in moral hazard rather than the budget. Combined with the drop in commodity prices (which I expect to continue), the less well off may finally get a decent boost, in stark contrast to QE2, which only helped high end Discretionary through the wealth effect. Nonetheless, disappointment is likely to arrive before any tonic from the Administration, so I would wait for a pullback before increasing Discretionary weightings, let alone those for other cyclical sectors. Cheers Sean
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Source: Bloomberg Finance LP