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The second quarter of 2009 is winding down and it is time for some retrospective analysis and a few forecasts. In the addition to the written commentary below, I've also recorded a video for MarketDNA, a blog which I maintain for the benefit of my Pepperdine University MBA students.
The S&P 500 rallied an additional 15% in Q2 with a practical absence of any meaningful pullbacks. Not unexpectedly this rally occurred alongside a weakening USD. This inverse correlation has proven almost necessary in the last few years to justify any meaningful increases in equity prices. In this particular circumstance, the weakening dollar reflected the so-called “reflation trade” when economic and monetary stimuli are injected massively into the economy improving demand but also creating inflation expectations.
Stocks and commodities as well tend to react favorably in this context and so they did. Inflationary expectations were not missed by bond traders who continued to unwind the overly aggressive long positions accumulated at the end of last year and in the face of growing government supply, yields started to increase.
The inflation/deflation debate is at the core of any economic forecast for the foreseeable future. We believe it is undeniable that some level of inflation will be the legacy of this dislocating economic period but we do not believe it is an issue at the moment.
The economic recovery seems very sloppy and certainly uneven. Unemployment rates are still growing (albeit normally a lagging indicator) and based on historical comparisons should continue to rise significantly. The most positive scenario would be a shift in the engines of growth from the US to the emerging markets, a move that would spur international economic growth and new found incentives to increase productivity. However, emerging markets, as exciting as they may be in the long term, just don’t have the critical mass or the proper balance between domestic demand and exporting policies, to be able to drive the rest of the world out of this malaise.
Economic numbers out of China seem foggy at best, manipulated at worst; Russia is completely dependent on energy prices and those are a function of global recovery (a circular relationship); Brazil and India could help but in due time and not in the short term. In terms of equity prices, emerging markets did outperform US stocks and for long term portfolios, I still think they represent a good bet and should be on everyone’s radar.
At this juncture, the problem is identifying whether equities in general are still undervalued and then identifying selective opportunities. The P/E ratio of the US market is now at best indicating fair value and not anymore any undervaluation; this is true of TTM ratios, forward looking ratios and CAPE ratios as well. Another negative seems to be the increased selling interest on the part of corporate insiders who were actually big buyers around the March lows. The stock/bond ratio also indicates overbought equities compared to bonds (even though such extreme was recently alleviated). Overall, the US market does not seem to be a compelling buy at the moment and that should skew investors’ attention toward more selective ideas and strategies.
MLPs continue to be high on the list for the income and the inflation protection built into their business model. Also the tax advantage may come in handy as this administration may move toward increases in dividend and capital gains taxes. Of course the increase in Treasuries yields reduces the competitiveness of MLPs distributions; however, the spread remains attractive.
Option trading was not as profitable as expected in Q2 as a persistent lower implied volatility versus statistical volatility made derivative arbitrage more difficult. Lower volume in options also increased the cost of trading and made this quarter a non-event. Looking forward we think an increase in volatility is likely and a more aggressive two-way trading environment may be developing which would be beneficial to our strategy.
One last comment on increasingly strange intraday trading dynamics; many professional players have noticed that while the financial system has returned to some level of stabilization, on an intraday level market dynamics feel strange and maneuvered. Many theories are circulating including the never ending conspiracy explanations. We are not sure concrete manipulations are indeed occurring but it is clear that many intraday moves are nonsensical; one possible explanation may be that in the absence of a coherent and general investment thesis as you would normally experience during normalized times, computer trading and quant based algorithms take over distorting logical intraday supply-demand relationships. The increase weight of institutional trading in dark pools and supplemental liquidity programs may be significantly distorting intraday internals. This is something for the regulators to investigate but in the meantime it is another new issue that has to be incorporated into any market analysis.
- Davide Accomazzo, Managing Director
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