Disclaimer. After nearly 40 years managing money for some of the largest life offices and investment managers in the world, I think I have something to offer. These days I'm retired, and I can't by law give you advice. While I do make mistakes, I try hard to do my analysis thoroughly, and to make sure my data are correct (old habits die hard!) Also, don't ask me why I called it "Volewica". It's too late, now.
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Wednesday, November 3, 2010
(If you click on the charts, you can see them in their original size)
I'm not sure how to read the rally since 5th July in both the S&P500 (up 16.7%) and the All Ords( up 12.3%). The Ozzie rally is easier to understand. Most of our exports go to booming Asian economies, our terms of trade have improved dramatically, and our economy is doing very well, so well in fact that the RBA has upped the cash rate again.
But the US economy is growing at half its trend growth, instead of the 2 or 3 times trend typical of a recovery. So why the US rally? OK, profits are doing well, but that's because firms are controlling costs by only slowly increasing payrolls. You'd think that consumer spending would also have been held back because of this, but the big GFC handouts have helped sustain PCE even despite a rising savings rate. The Tea Party crowd will ensure fiscal tightening intensifies, a good reason to be cautious about both profits and the US recovery. Yet without government support, consumer spending can't hold up, and already the first signs of weakness are emerging (see the latest monthly PCE data). So for companies, the top line will cease growing, implying that collective cost cutting will no longer benefit the bottom line, as it has done so far in the recovery. But it's hard to see it continuing to work.
OK, what else will keep profits rising? A falling dollar will do wonders, both via a direct effect on profits from overseas subsidiaries but also as a result of higher sales. But a falling dollar will intensify the headwinds facing Europe and Japan -- unless they also embrace the drug of quantitative easing. So really, what the market is saying is that it's going up because of QE. All the same, debt hasn't gone away (more of that in another post) and monetary easing works better when you can get negative real rates, which is very hard when inflation is close to zero. There's a lot riding on Bernanke's helicopter.
Markets are close to previous highs and are fairly fully valued on trailing PEs (which I use because prospective PEs are doubtful, in all honesty). They're also fairly overbought. It may be a typical mid-term correction (though it was sharper than normal) and QE may save the world. I'm worried, all the same.
Posted by Nigel at 9:02 PM