Recent results from Caterpillar, for example, have been above expectations on the back of better than anticipated sales abroad. In fact, Dow constituents have reported earnings increases for the first quarter of some 18%, exceeding estimates of 11%. In sum, large -cap US stocks are benefiting from global growth, and this had a positive impact both on the market sentiment and valuations.
The Dow is trading at approximately 18 times historic earnings, below the 22 times of October last year when the market was at a similar level. Interestingly, profits have risen for 16 consecutive quarters. But what of the visibility of the future?
Lack of visibility
Our primary concern is that global pressures keep building, yet markets - currently surfing a wave of liquidity - are hitting new highs. Clearly, these divergent forces are incompatible but we see little sign of the situation changing very short term, with vast quantities of speculative money continuing to flood global markets. But fear is evident despite the bullish mood. For example, the markets fell heavily at the end of February after a sell-off in China. This was not limited to emerging markets. The correlations are high in a market moving swiftly downward and history has shown that the trigger for such moods often comes from outside the US.At the end of February, the Dow fell 1% in a day and continued to fall ending down over 6.5%. Newsflow relating to durable goods orders, mortgage problems and falling consumer confidence caused nervousness. But the initial cause was abroad.
Subsequently, the markets have bounced, despite the news being either mixed or worse than expected. It is this lack of visibility that concerns us. Are developed market investors sure about the global visibility, the extent of growth in developing economies and their ability to support global growth?
The question is - are markets complacent? The global macro picture is currently benign but there is little doubt that creeping complacency is a key risk as we move forward. Investors simply do not seem to be asking the right questions at an early enough stage and that lack of inquisitiveness could, in our view, prove costly.
The key pressures on global markets are, of course, growth and inflation. These pressures are by no means exclusive to the US - whose market, like the global macro picture, is fairly benign - but there is little doubt that the US is mired in uncertainty. The US economy, for instance, appears to be struggling to shake off the effects of the first-quarter slow down, with existing home sales falling 8.4 per cent in March following a near 4 per cent gain during the previous month.
Gasoline prices are accelerating - up 23 per cent in 2007 - and this rising cost, combined with the housing market gloom, is increasingly weighing on US consumers. Indeed, the Conference Board's consumer confidence index in April fell from 108.2 to 104 - its lowest level in eight months and below 2006's average of 105.9.
The IMF has cut US growth forecasts from 2.9% to 2.2%. Numerous analysts have forecasted growth below 2%? Do we believe that the risks of a slowdown are evenly spread? Will the US consumer be able to weather the storm? What is the likelihood of contagion globally as a result?
An uncertain future
Whether this weakening will curb consumer spending remains to be seen. But the point is that there is real uncertainty here, in the same way that no one can confidently predict which way the Federal Reserve will go given upside inflation risks and below-trend GDP growth. Nor can anyone say for sure whether contagion from sub-prime problems will worsen, although it is a real threat.Indeed, the data coming out of the US continues to be benign but, crucially, it is often on the poor side of consensus. Consider the oil price. Very few people were predicting that it would breach the $65 a barrel level again without further geopolitical woes, yet where is it now? In fact, recent US economic releases have shown that the consensus is often wide off the mark.
For instance, in March, the following data came out: University of Michigan Confidence; ISM Manufacturing; Consumer Confidence; MBA Mortgage Applications; Existing Home Sales; Existing Home Sales (MOM); and Initial Jobless Claims. All of them came in worse than expected. (As did both the month-on-month and year-on-year CPI indices in February.) The Commerce Departments price figure was up 2.4% in February, above Mr Bernanke's acceptable range of between 1% and 2%. Furthermore, interest rate futures suggest only a 30% chance of a rate cut in August.
It is not just the US, however. The uncertainty is global. China, for example, is a major concern. There is no doubt that the Chinese authorities will continue to apply the brakes on its rampant growth, which is considerably ahead of consensus forecasts.
The major threat is that the Government will become even more aggressive in its attempt to slow growth, which might not necessarily dent the carry trade, but it will most certainly have an impact on commodity prices - and if that happens, then equity markets will suffer in the short term.
Indeed, commodity prices are extremely high at the moment and, at some point, these prices must affect input cost - and therefore inflation. But the markets do not appear to be factoring this in. Even the more risky emerging markets have been relentlessly pushing higher.
Complacency abounds
The issue, again, is the threat of complacency. Market visibility is poor, but investors are continuing to invest in droves, seemingly without understanding why they are invested.A telling indicator of this is the increase in the number of overbought stocks in global markets over the last couple of months. A good example is Astroc Mediterraneo, a real estate development company based in Spain, which is currently trading at around $15 - considerably lower than the $72 level it reached in February. (The same company's shares slumped to a 12-month low of $6 in May 2006). The volatility is simply down to liquidity and irrational behaviour.
The carry trade continues in force. However, we see several factors that could eventually start to working against carry. These include the changing fundamentals of AUD and NZD, India opening their capital account more quickly, and China's strong GDP and CPI.
It is clear that many over-bought companies are simply not worth their market cap. Standard Bank in South Africa, for instance, is up 26% since before the market fell last May, in an environment that has inflationary pressures, rates that have yet to peak, a debt-to-disposable income ratio that has risen to more than 70 per cent from around 50 per cent, and a yawning current account deficit. Global property pressures also loom in the background, and South Africa would certainly not be immune to a downturn in this area.
Looking for the warning signs
It is in these markets that hedge fund managers should really earn their corn. But shorting into market strength is psychologically difficult, and can often result in short-term underperformance (especially as shorting decisions should be taken early).When asked why we are so aggressively short - over 20% net short in fact - we reply: if not now, then when? Growth and inflationary pressures are clearly mounting. Inflationary pressures could - and probably will - delay interest rate reductions generally. That would put liquidity under great strain, and in all likelihood, trigger a global sell-off.
But markets do not seem to be taking this threat seriously. Valuation expansion will, in our opinion, not occur if rates do not decline this year given current market levels. At best, stock prices will increase with earnings growth, with no valuation multiple expansion.. But are the best earnings behind us, and the risks ahead? The VIX index, inter alia, may be hinting at this (see Fig 1).
Crises can come from anywhere, of course, and sometimes there is nothing investors can do to mitigate it. Were bond investors last year forecasting the extent and speed of delinquencies in the US loan market? They had no idea, and this is not a minor problem: indeed, it is likely to cost them in the region of $60bn. It was, quite simply, a bolt from the blue. Not unlike the current Spanish experience.
But it is when the warning signs are in evidence that investors need to think about why they are investing. Is there sustainable supportive news flow that lasts for longer than a month? Is the US heading in a clear direction given where valuations are currently? Are rates heading down or up? Is the bond market heading into a prolonged bear market? Are the US housing market problems contained, or spreading? Are we looking at a peak in merger and acquisition activity, which has been buoyant for a couple of years now? (Amazingly, the market appears to be saying that M&A is highly supportive of these liquidity-driven markets - but at the same time, it is suggesting that management are acting out of 'desperation' and are diluting shareholder value - eg Sherritt).This, to us, does not seem like an environment in which markets should be pushing through new highs. There is simply no clear picture short term. We are going through a turbulent period, not unlike the same time last year, but the difference now is that markets are significantly higher and challenging old highs. Is this rational - ie, based on good, clear fundamentals and supportive news flow? On the contrary, it appears to be driven by irrational liquidity chasing 'a good thing'. For us, it is the right time to be taking a step back and asking why you are invested - before it is too late.
The risk of being early, as usual, is short term underperformance. But should markets be pushing new highs ? We do not believe so.
The views expressed are those of Bryan Collings and do not necessarily reflect those of Hexam Capital Partners. Facts and figures are correct at the time of writing.
