The following was written by Jawad Mian, Portfolio Manager based in Doha, Qatar
I have tremendous respect for Akram Annous, a 30-something market intellectual, a mad scientist if you will but without the hair. He is a great writer and friend, and we both share a similar passion for the global macro world. We also both share a similar aversion to The Bernank. For the last 3 years we have largely been in agreement on our views about the world and where to invest. Lately, however, we seem to be fighting about everything. Like a married couple, we can’t seem to agree on anything. Never before have our views been so divergent. Never before has reading his writing caused me so much pain. I had had enough. It was getting ridiculous. So I proposed we have a sit down, scratch our heads, and let it all out. ‘The Great Debate’ is what ensued. It is kindly attached for those eager few who would like to read our silly musings. Have a sexy weekend.
Jawad: I believe the US market is making a transition to a new phase that will result in slower price gains and higher price volatility. That’s not unusual as corporate profits begin to settle down to a more steady state or long-term trend and earnings growth naturally slows. The easiest part of the bull market is over and we can see market correlations fall further. But we are not on the verge of a new bear market in my view. The market trend going forward will be a lot flatter but still upward biased. I expect the S&P to make new highs. Liquidity, economic momentum, and “valuations” are still supportive of further gains.
Akram: Sorry Jman, but I am going to have to say BEAR! We are headed lower. And I’m not even thinking about an entry level to buy stocks yet.
Since economies are cyclical I like to use Shiller’s S&P CAPE ratio when I want to look at equity valuations. Presently, it’s flashing extremely expensive. I’m a big believer in the fact that equity multiples are going to contract, maybe even to extreme historical lows. We are already seeing signs of this in some sectors like financials or large cap tech, both of which make this bull look a lot more like a bear in disguise. Low rates and cash rich balance sheets are byproduct of an economy facing structural challenges and more likely than not a protracted period of subpar economic growth.
Look at Best Buy. They beat earnings estimates. How? They borrowed $700mm and bought back $500mm in stock. At the same time they slashed prices to move product, and cut more overhead. The stock looks cheap as management is massively buying back stock, but is this a business you want to own right now? Almost everything they sell can be bought in an aisle at Wal-Mart or Target and definitely on Amazon. The multiple will continue to come in because longer-term the growth isn’t there. Best Buy’s problems are structural, and that’s how I view most of the US economy these days. When you combine that with the fact that corporate margins have likely peaked, the dollar devaluation won’t be a tailwind for most global corporate top lines anymore, and a Fed that can now do nothing but sit and watch; you should be wary of equities. I will however concede that companies most leveraged to emerging market growth should fare better, but when you consider the current relative size of the US economy to the rest of the global economy that’s not saying much.
Jawad: I don’t disagree with your assessment of the economy. I share the same view. However, making a structural case for the economy does not help you time cyclical investment opportunities in markets – the 6 to 12 month outlook. Four months ago, everything lined up for a great short trade and I thought we could lose 20 percent easy. But the market chose to correct within a 10 percent range and consolidate sideways over a period of four months. The current weakness may persist, but I still view it as a buying opportunity seeing as we are closer to the lower end of that range. The window for a major decline has now closed.
Most of the overbought conditions have slowly worked off and sentiment has turned decisively negative for stocks. Financials are breaking down but you don’t need them to rally for the market to move higher. It is not a reason to worry – unless you see rising rates or another financial crisis. I don’t see both happening any time soon. Rotation can be good. Tech needed to breath and energy still looks great. There could be a 5 percent slide here but I want to buy into that. The cyclical uptrend in stocks is not over.
Akram: ‘Buy the Dip’ is over Jman. The Bernanke Put has expired. Your bull was nothing more than the work of a clever illusionist.
Jawad: Do you even remember what it was like to be bullish about something??
Akram: Yes, the lobster dish at Zuma. The only perma you will find here is perma-frost as we enter a new ice age for equities. You can’t change my mind. I’m a big bad bear!
Jawad: I’ve danced with the bears, now it’s time to ride with the bulls. That sounded better in my head.
Akram: Yields are going lower. US households have less than 2% of their nearly $50 trillion of financial assets in Treasuries. Most of this household wealth is tied up in the aging baby boomer generation. As they shift to capital preservation mode, they will buy more and more Treasuries despite all the fiscal worries. Who wants to fight that tape? Let me see it get over 5%, and I will be willing to take a second look. And this is before Uncle Sam starts calling for them to do so with clever patriotic ads. Also, the unfunded or underfunded obligations we here so much about don’t really concern me. Americans will just have to get used to a lower standard of living. You will retire later and have to pay more out of pocket for your healthcare.
One day, a stroke of the pen will eliminate most of these Medicare and Social Security obligations we are so worried about today. Since The Bernank signaled the end of QE2 is on schedule this past February yields have plunged. Why is that? If he was supposedly supporting this market, shouldn’t his exit cause yields to rise? If you ask me, it’s the QE that kills treasuries by causing dollar angst. Take it away and we will resume our long-term descent. We are headed to the low 2’s on the 10 year over the next 18 months.
Jawad: Wow, I can’t believe you just said that. I just downgraded you in my head. This is what happened: we reached February and it was easy to see markets are vulnerable, sectors are overbought, relative valuations are not as exciting, and economic data will weaken. Yields had come off nicely so you could buy safety there. Markets come down; government bonds catch a bid and rally. That’s it, plain and simple. You give too much credit to The Bernank. Who listens to him anymore? The Treasury market was quick to discount an extended slowdown and appears overvalued. The Treasury rally needs QE3 to continue.
My view is that current yields are at the bottom end of a range and more likely to shift modestly higher than lower in the coming months. The economic surprise index has fallen even further than it did during last year’s growth slowdown and reversals in the surprise index have been well correlated with reversals in the Treasury market, suggesting that the risks for yields are now skewed toward the upside. The same index pointed to lower yields from the highs in late February.
I don’t see how we can sustain below 2.60 on the 10 year. I would use any further strength to accumulate short positions at the longer end. Extremely low real Treasury yields highlight that investors do not require any fiscal risk premium at the moment – that is likely to change at some point over the next 18 months. Think about it, even a 5% bond rate on the 30 year extrapolates to only 2% inflation for 30 years. I can’t buy into that. Not with The Bernank at the helm as the monetary bartender… I’m not drinking that Kool-Aid!
Jawad: The dollar is going down, down, down. The biggest unappreciated risk to the global macro picture is a “dollar crisis”. That is, a swift decline in the dollar. If it is orderly, that’s okay. But if it is quick and swift – like a crash – then that’s a huge problem. I’m of the view that that’s where you will see the market show its disgust towards the US fiscal theater at play over the coming years. It would be a “dollar crisis”, as a result of the fiscal disaster.
It is argued that the US cannot default. All US debt is denominated in dollars and the Fed can print as many dollars as needed to repay creditors. Even if that’s technically correct I believe it is irrelevant for the holders of US debt. Getting repaid 50 cents on the dollar is the same as getting repaid in a dollar that only has 50 cents of purchasing power. I see no real possibility of a drastic change in policy to avert this outcome. I’m very, very bearish on the US dollar.
Akram: Currencies are a relative game, and right now I’m more bearish on the Euro. I think Trichet must be running monetary policy from a cloud based computer. He is talking about raising rates again in July while I expect him to have to reverse course and cut again. Europe’s economy is for the most part less dynamic and productive then the US, and it probably has even worse structural issues when you look at it as a whole. The manufacturing volatility in this economy is in Germany. The debt problem is on the periphery. The innovation is non-existent. And the sovereign cancer in the banking system has most likely already metastasized. Wait for the China demand boom that is the German engine to slow and watch what will happen. Add in the Fed exiting QE2 right now and you have to really like the US dollar against the euro.
Jawad: Only short-term. I still favor staying broadly short the US dollar. I don’t see how it can sustain a powerful advance like the one we had in 2008 anymore. The world has changed.
Akram: 2008 was a panic. The last three years have been a combination of that fear unwinding and an intentional move by the Fed to provide relief from the Fisher Dollar disease which The Bernank is oh so obsessed with and an expert on. We will settle somewhere in between, but I am wary of the bartender.
Akram: They are a growth story, and probably driving 90% of what is working in global markets these days. But even the best growth stories experience major bumps along the road. China is approaching a big one. While most people are worried about inflation, I see a deflationary bust around the corner in this economy. We’ve been talking about a housing crash for several years; it’s finally starting to happen. A slowdown in fixed investment and the paper tiger remerges.
Jawad: I don’t see a deflationary bust. I view the recent poor performance of the Chinese market as cyclical rather than secular. The weakness in China was policy driven and the policy environment is turning progressively supportive for stocks. China is in the late stages of its tightening and money growth has declined sharply. Real estate stocks there have stopped underperforming the benchmark which is a positive. Copper is soft but not collapsing. Being a China and commodities bear is not contrarian anymore. I like the odds here and expect a recovery rally later in the year.
Akram: I’ll stick to betting against the Chinese economy and not Chinese equities in general as I don’t see much excess there. Though I am sure bank shorts will work well once the real estate problems really get going. With price to income ratios close to 40x in Beijing and residential investment at 9% of GDP versus something closer to 5% for Japan during the 1980’s, you are not going to get me to back off this bubble. Anyway, we must go to China.
Gold and Silver
Jawad: Love it!!! I consider precious metals to be the single best investment right now, buy and forget. But I’m even more excited about the shares. The gold and silver mining stocks should perform strongly in the second half of the year and over the longer-term. Gold mining stock price/earnings ratios are near multi-year lows and gold mining companies have systematically reduced hedges on future production thus offering a better play on higher gold prices. I strongly believe that one should hold a basket of juniors. I’m buying right now.
Akram: It’s been fun. I’d still probably hold some gold in a diversified portfolio, but I am not prepared to switch to a precious metal store of value regiment anytime soon. Silver was a bubble and it probably still is one, basically, it’s a great asset for speculators in either direction. Let the euphoria around gold subside some, and I might be willing to take a look. But overall too consensual for me, and I was a bug for several years.
Jawad: The only bubble right now is the way you think! Mark my word – silver is going to be above $100 by the time I turn 30. How old will you be by then? You don’t have to answer that.
The Global Economy
Akram: Down but not out. There is a once in a lifetime shift going on here. Wealth transfers like we are witnessing don’t happen very often. We will eventually find a balance, but it is going to take some time.
Jawad: I generally agree with that. I used to be a “double dipper”, but I don’t see that risk anymore. But I do see the risk of not being paid bonus again this year.
Jawad: I find the politics more interesting than the markets right now. But to put it simply, I believe the Gulf markets will do well over the medium-term. I like Qatar and Saudi Arabia. I have a very positive energy outlook and I believe energy-related investments will fare well over time. Higher oil prices will lead to a higher level of public spending which should lead to a higher rate of contract awards for some of the listed players and higher earnings. The return of liquidity should also find its way into the equity markets.
Akram: I have to admit that I am not too excited about equity markets in the region right now. There was a period of extreme volatility that coincided with the political/social turmoil that was great for making money in equity markets (Saudi and Egypt in particular). If you missed that or got caught in it, you most likely are going to end up having a tough year. Overall, Saudi and Qatar equities have held up the best, but I am not too excited about either equity market for the remainder of the year as I see them more exposed to an Asian demand drop-off. If you want to chase MENA liquidity, go buy some credit. Fixed income has been the place to be, and it continues to be the place to be. Look at how paper like the DIFC Sukuk, Emaar convert, and Aldar convert has fared over the past six months.
Jawad: Credit is boring, I prefer stocks. There are plenty of risks to monitor, however. The biggest of which is the Kingdom’s succession problem. King Abdullah of Saudi Arabia is close to 88 years old and in frail health. His brothers, though less revered by the Saudi people, are not any younger or doing any better health-wise. The sudden demise of King Abdullah would almost certainly stoke fears of social unrest in Saudi Arabia. That could really spoil the royal revelry. However, there is no way to predict the precise timing of the King’s death. I already checked with Goldman.
Jawad S. Mian
Direct: +974 4405 6557
Email: jmian -at- qinvest.com
PO Box 26222 | Doha | Qatar