Posts by the Contributor
Katrina Lamb, CFA
Head of Investment Strategy & Research
Katrina Lamb’s international investment industry career spans more than 25 years and includes both buy and sell side experience. She specializes in the research, analysis, and evaluation of the capital markets opportunities that... Full Bio
Over the past several days we have been treated to the spectacle of an unsavory phone hacking scandal that has metastasized into a full-blown politico-media scandal shaking the upper-crust branches of the British governing class, forcing a reluctant humility on the pashas of an arrogant media empire and making threatening growls from the recesses of that empire’s US stomping grounds as well. Now, what Rupert Murdoch, News Corp, UK Prime Minister David Cameron or any other personage or organization are or are not guilty of is not the point of this post. And as far as I can tell there is no obvious connection between this scandal and the other spectacle of the week – the playground theatrics of the US Congress whose members taunt each other with a rhetorical “Are Too! Am Not!” level of sophistication.
But these two stories are simply different faces – each ugly in its own distinctive way – of a larger and seemingly unshakeable presence in our lives today. That is a chronic, all-pervasive mistrust of institutions on the part of just about everybody who is paying even a modicum of attention. Mistrust begets uncertainty, and uncertainty is what investment markets hate more than anything else in the world. In this light it is not surprising that the dominant paradigm in the markets today is a bipolar, trigger-finger “risk on / risk off” pattern of behavior. One day the world is about to fall apart and everybody wants to do nothing other than hoard gold behind fortified ramparts. The next day investors look at the same news, see the glass as half-full or at whatever level is necessary for hope to spring eternal, and rush out to buy primary shares in some technology 2.0 IPO with a dicey revenue model. And so it goes, back and forth, day in and day out.
This is not rational behavior, in the sense that it is far removed from the “Rational Man” theorems that have filled economics and finance textbooks for decades. But in a way it is an understandable response to the world of mistrust that permeates the modern mind-set. We begin to just assume that massive conflicts of interest exist at every nexus of money and power everywhere in the world. We assume that the ones who actually get caught with their hands in the cookie jar are a small percentage of all the double-dealing and clever scams being hatched and executed – and we further assume that in most cases no one will actually pay the price even if they are caught. We hear the accused and their lawyers dissemble about what they did, what they didn’t do, how they managed to thread the needle through the conflicts of interest and the attendant multiple temptations without coming up on the wrong side of the law. We start to believe that words don’t really matter anymore.
Our better angels say no – that is not how people invested with the public trust behave, and they must know that in a capitalist economy public trust is our single most important currency. But our daily experience nags at these better angels, and with every new empirical data point we think, no, this is not the exception, it is the rule. Am I feeling lucky today? Hello, Wingandprayer.com IPO. Had enough? Time to haul those gold bars over the moat and into my cellar. Maybe tomorrow will be different.
In the time-honored Greek myth Pandora, blessed by the gods with abundant beauty and talent but also an overweening curiosity, opens the box and allows all the Ills to pour out into the world. In her despair Pandora quickly shuts the box but by then there is just one thing left inside – Hope.
Hope was in abundant supply today as well as the shares of Internet music company Pandora came streaming into the public securities markets with opening day gains in the neighborhood of 62%. But it is probably going to take more than a wing and a prayer to make it unscathed through the buzzsaw environment of the market these days. Sharing the headlines with Pandora today were the “Zombie Consumers” – a rather stark portrayal by longtime Morgan Stanley economist Stephen Roach of the bleak landscape of US consumer spending in the age of subpar growth, sticky unemployment and debt as far as the eye can see. With the exception of Pandora-mania risk markets today are decisively buying into the Living Dead point of view – the S&P 500 is flirting with its 200 day moving average and testing the 2011 low of 1256 reached on March 16.
Correction territory? Not quite – as of the writing of this sentence the index is trading around 1263, which puts it at 7.2% below the recent high of 1361 attained at the beginning of May. A technical correction requires a downward move of 10% - but that is hardly out of reach given the trading patterns of the past several weeks. “Sell in May and go away” is ringing true as we head into the summer months.
This seems to be the Yogi Berra of summers – “déjà vu all over again”. Greek protesters in the streets of Athens, an internecine war of words between German policymakers and their counterparts elsewhere in the EU, fears of a US double-dip recession consuming bits and bytes of media real estate. No wonder markets got all in a snit last week upon hearing that the Fed has no apparent plans in its head for a quick fix of QE3 to keep the adrenaline rush going. Investors clamoring for more stimulus have a point – if fundamental conditions today are in many important ways little changed from where they were a year ago, then how has the calculus changed away from the need for another round of intervention?
Perhaps it is time for the Fed to take the morphine away and let the natural healing process take effect. Quantitative easing, like any monetary policy, can be at least somewhat effective when applied in measured doses. But it does not make the organic problem go away. The “organic problem” in question here is the fundamentally changed socio-economic conditions of the centers of the developed world economy – the US, the Eurozone and Japan. Each of these centers faces deep-seated challenges to its health unlike any that we have seen since the second half of the 20th century. It is well and good to say that growth engines like China, India and Brazil can pick up the slack and keep global growth humming along, but in reality the fates of the developed and emerging worlds are intertwined. We believe that countries and markets will find their footing – that is the case more often than it is not – but consumer zombies and other unsavory denizens of the night will likely be an ongoing part of the landscape.
Some market corrections are like sudden hysterical meltdowns – dramatic and immediate. They erupt and send everyone to man the panic stations – and then just like that they are over. Investors come wading back in to snap up bargains and the world moves on. Most of the market corrections during the Great Bull Market of 1982 – 2000 were of this variety, most notably the short-lived freefall of Black Monday in 1987.
Other times, though, bear witness to a different kind of correction, and right now we are in one of those times. This is more like a slow-burning funk than a dramatic meltdown. The S&P 500 reached its 2011 high point (to date) back at the end of April. Since then the index, and most other equities indexes, have been stewing in a six week funk. The stock market’s losses have been the bond market’s gains – the Russell 3000 ended June 7 up 3.3% for the year to date, and the Barclays US Aggregate Bond index closed at 3.2% for the same day – virtual parity.
It is worth recalling that this pattern is not entirely different from one year ago, indeed for some of the same reasons. Then, as now, concerns about Greece and other Eurozone tinderboxes were spooking risk asset markets. The global economy was trying to find its footing and getting there in fits and starts. Summer usually means lighter trading volumes than usual, so price trends tend to be accentuated. But there was one significant difference. Last summer the Fed announced its intention to embark on a new plan of monetary stimulus in the form of quantitative easing – QE2. That announcement sparked a rally that took equities and other risk assets sharply higher through the end of 2010 and into this year. Now, QE2 is coming to an end this month. In a press conference on June 7 Fed Chairman Bernanke appeared to stick to the Fed’s position that there will not be a QE3. Markets promptly resumed the slow-burning funk after being comfortably higher for most of the trading day.
The easy answer to formulate from this is that investors lack the confidence to flip the “Risk On” switch without regular fixes from the Fed’s store of steroid juices. There is no doubt some truth to that, but in our opinion that is not the important story. Indeed, the expectation going into yesterday’s Fed conference was that there was no QE3 plan anywhere visible to the naked eye. If Bernanke had suddenly announced a plan it would almost surely have turbo-charged the markets for a day or so, but it would also have meant that the Fed took another look at overall conditions and came to the conclusion that the economy was still unable to stand on its own two feet. Euphoria would have quickly ceded to sobriety and fears that things were much worse than they appear. Analysts would start revising their earnings expectations downwards and market valuations would follow as surely as night follows day.
So here we are with the training wheels off, taking the first hesitant pedals without Uncle Ben keeping the bike steady. If we can keep from falling over in these first few moments, that could be a sign of a more tractable and sustainable underlying strength that could in turn pull risk assets out of their funk.
Just two months ago the beleaguered second-tier European economies were the darlings of global equities. As of March 25 the MSCI Greece country index was up 22.9%, while Spain, Portugal and Ireland were all turning in double digit performances. Their debt problems hadn’t gone away, but investor sentiment appeared predisposed to look on the troubled nations with kindness and favor. For Greece, anyway, that song is over for now. The MSCI Greece index closed on May 24 at -7.6% year to date, thus falling 30% from its springtime highs. Feel like déjà vu all over again? May was crisis month in the Eurozone in 2010, and thus it is again. It’s the same set of problems – a moribund economy with no catalyst for organic growth as far as the eye can see, against a backdrop of global economic uncertainty and a great deal of internecine bickering among EU parties as regards what to do – or what not to do. Of course, when you say that you have the same problems you did a year ago it doesn’t really mean they are just as bad – it means they are one year worse.
The Eurozone debt crisis has not really been a front page issue for most of 2011 – it has been crowded out by numerous other stories of a seemingly more dire nature, from crisis flashpoints in the Middle East to natural (and man-made) disasters in Japan, sky-high oil prices and all the rest. But it has never gone away, and its presence acts as a continual reminder of the fragility in market valuations. The year to date has on balance been kind to risk assets – the Russell 3000 is up around 7% – but it has not been the kind of solid performance that inspires confidence. Indeed, many of the market’s bright spots so far in the year have been in those European equities markets. The MSCI EU index is still up 7.2% year to date, but the luster seems to be fading that region. Japan is already dragging broader developed international indexes lower – the MSCI EAFE index is up only 2.4% year to date largely because of Japan’s weakness and generally lackluster performance so far in the developed Asia Pacific markets of Singapore, Hong Kong and Australia (New Zealand, oddly enough, is doing quite well in comparison to its regional brethren). And emerging markets in general have been having a bumpy ride of it so far this year, with the key growth markets in a bit of a holding pattern and the usually dynamic regions of Asia and Latin America trailing the broader indexes.
In the US the performance leaders continue to be in midcap generally and in growth over value. Interestingly, though, the Russell 200 Megacap index and the Russell 2000 Small Cap index have just traded places for the first time since January, with megacaps now turning in a slightly higher performance for the year to date. There is no small contingent of US equities investors who would love to see their long-awaited megacap rally take place – it’s been a case of Waiting for Godot for longer than any of them would care to remember. Time will tell. The economic picture continues to be muddled – housing figures and durable goods numbers posted this week were underwhelming, the consensus economics forecast is below 3% again (it was around 3-3.5% at the beginning of the year) and the jobs outlook continues to be muted even though weekly jobless claims have continued to fall. It may well be time to recall the time-honored adage: Sell in May, go away. Or not.
It’s not like we didn’t have enough to worry about, after all – tepid economic growth, budding asset bubbles in debt and commodities, and sundry debt crises are more than enough thank you very much – so why did the head of the IMF have to go and wind up on suicide watch in Rikers Island jail? Dominique Strauss-Kahn may not have much in the way of judgment-exercising capabilities in his personal life, but by all accounts he has been a linchpin figure in the protracted financial problems in the Eurozone, reputed to be just about the only financial policymaker to whom German Chancellor Angela Merkel will listen. This is not a good time for yet another X-factor to suddenly emerge from its quantum superposition into our observed reality – but here we are.
It is a measure of Strauss-Kahn’s success in managing the process of dealing with the Eurozone debt crisis that it has largely stayed off the front pages of the financial media and has failed to spook equities markets unduly. But the lack of visibility does not by any means indicate an imminent resolution. The fixes applied to keep Greece and Portugal from going over the edge are wobbly, and the kind of organic economic robustness that would improve the competitive positions of second tier European countries is not visible to the naked eye. Tough decisions will have to be made in the near term, and Strauss-Kahn has shown himself to be that rather rare specimen of technical bureaucrat with the force of personality to make the tough decisions. All the more pity that the “force of personality” was so completely and inappropriately directed as pertains to his off-duty adventures.
What are the immediate implications for market performance? Well, as we noted above, anything that adds to the already potent cocktail of volatility is most unwelcome. Assuming that regardless of how his legal predicament works out, Strauss-Kahn has put himself beyond the pale as a viable ongoing leader of the IMF, it may be some time before we fully appreciate the practical implications of his stage exit for the Eurozone. But turning up the volatility dial can accelerate what we see as in high probability the biggest concern in markets today – the expanding bubble in debt and commodities prices. Energy, metals and agriculture prices have tumbled in recent days but continue to spike up and down by large leaps on a daily basis. Yields on the 10-year Treasury note are down about 12% from their levels three months ago, leaving one to wonder what pixie dust can continue to sprinkle over government debt markets to keep their prices from going into a severe nosedive. Curiously, when you look at market performance in the year to date the most stable returns trends seem to be in equities. That could of course change on a dime if the froth in other asset markets continues to build up. The probability of a very bumpy second half of the year appears to be gaining ground. It is indeed a shame that one of the better financial policymakers out there had to take himself out of the action in such an ungainly manner.