I try to step back periodically and think about my investing posture and the macroeconomic landscape. The end of the third quarter is a good time for that.
I’d like to first briefly mention some of the data points that have caught my attention over the past few weeks. This is not comprehensive. Rather, it is more an attempt to highlight some salient information and indicate the ‘flavor’ of recent economic data.
Negative or disappointing data points include:
- Capacity Utilization in the US had the biggest decline since June 2009, falling to 78.2% from 79.2%
- Empire manufacturing survey registered -10.4 with declines in both new orders and employment
- ISM-Chicago Business Survey: 49.7 (Below 50 indicates economic contraction, this was the lowest reading in 3 years, with corresponding declines in new orders and employment)
- Durable goods orders excluding aircraft and defense was down 0.9% after dropping 1.1% the prior month
Select positive data points are:
- The Dallas Fed Manufacturing Activity Index came in slightly better than expected at -0.9, with new orders increasing versus the prior month and employment also growing (though down from August)
- Weekly initial jobless claims improved to 359k (they had been hovering around 380k)
- Regional Fed surveys show high degrees of optimism, with the Richmond, NY, Texas, and Philly Fed surveys all showing businesses expected brighter conditions six months ahead (and levels of optimism generally ticked up from levels in August).
Again, this is a sample, not a comprehensive list. I tried to be balanced in presenting data. Importantly, more of the meaningful data points (ie capacity utilization, durable goods orders) suggest economic stress. I count more negatives than positives.
Economic stress does not seem to be reflected in stock prices. Stock markets in the US were up about 2.5% in September. Further, European sovereign debt seemed less risky to investors in September, with Spanish 10-year bonds falling from 6.4% yields one month ago to 5.9%, and Italy’s 10 year bonds dropping to 5.1% from 5.8%.
Why might there be a disconnect in the markets? Some possible reasons include:
- Economic data points that I cited above are backward looking. Stock markets could be reflecting expectations for improving conditions from depressed levels with the worst now being behind us.
- Central bank interventions might be distorting asset prices. Recall that over the past month, the EU, the US, and the Japanese central banks have engaged in massive quantitative easing programs. By creating money and buying assets, they are injecting money into the financial system (also displacing other investors who subsequently buy other assets including stocks), sending prices higher. Further, central bank interventions create expectations of asset price increases. This can create a self-fulfilling cycle of higher prices.
- Actual expectations (“whisper numbers”) could be more pessimistic than published expectations suggest, such that even bad data is could be positive in the eyes of market participants as a group.
Given the mixed data (albeit with a negative skew) coupled with central banks intervening to move asset prices higher, I am not inclined to forecast the market direction. Does negative economic data supersede and lead to generally downward earnings revisions? Does money printing lead to new highs for the markets? I don’t have these answers, and, as such, these cannot be the foundations for making investments.
From an investing standpoint, my perspective has held fairly steady. I am comfortable with a low net exposure (a bias toward being short). This reflects, at least in part, my concern that an economic shock could emerge, and I want to be protected. Admittedly the cost is that I will not benefit from big upward market moves.
Moreover, many individual stocks trade with PE ratios at the highest end of the range I have historically observed, with several of these in excess of 25x 1-year forward earnings. This doesn’t preclude stocks going up, but it suggests that expectations are already lofty. As far as catalysts go (a critical element in getting comfort with shorts), I have specific expectations that should result in meaningful declines for certain stocks. In these cases, the direction of the market in the long-term should not matter.
I understand the view of those who would trust liquidity to push prices higher. For me, the combination of potential shocks and high valuations leads me to give equal weighting to my dual mandates of protecting capital and generating returns.