Monday, January 23, 2012

Global healing, 2012 vs. 2009

Further to my post last week detailing signs of global healing, I have had a number of discussions with investors about the market outlook based on the events of 2008-2009. If we are indeed in a period of global healing, then can we expect the kinds of returns from stocks that we saw coming off the March 2009 bottom?

The answer is a qualified no.

Consider this chart of US equities spanning the periods in question. In 2008, the market crashed in the wake of the uncontrolled collapse of Bear Stearns and Lehman Brothers. In 2011, the European authorities manage to stem the panic. Both episodes are marked in the red boxes below.

In late March 2009, the Asset Inflation Deflation Trend Model moved from a deflation reading, indicating maximum defensiveness, to neutral. The same thing happened about two weeks ago.

Here's the difference. In 2009, the market crashed. In 2011, the market didn't. Moreover, many professional investors were positioned for a crash but their performance was hurt by the confusion over the political and economics of the eurozone crisis. As a result, hedge funds and the average long-only manager had a terrible 2011.

The road ahead in 2012
So what happens now?

I would like to discuss the outlook for return and risk for risky assets such as equities. First, because the market didn't collapse in 2011 as it did in 2008, it would be foolhardy to ascribe near triple digit returns for equities going forward. If there are no accidents, such as a US recession, or a Chinese hard landing, investors should enjoy either high single digit or low double digit returns from a diversified stock portfolio.

The changing risk map
What has changed in 2012 is the map of risk. The actions of the ECB, Federal Reserve and other global central banks have effectively minimized tail risk for investors. Instead of having to worry about a market with a bimodal distribution, which Pimco manager Vineer Bhansali wrote about here, and is shown in the graph on the right below, I believe that stocks and other risky assets have returned to the classic unimodal bell-shaped return distribution shown in the graph on the left.

In other words, instead of worrying about catastrophic events, such as a Creditanstalt-like collapse, we just go back to worrying about earnings, recessions, growth, interest rates, etc. Bimodal distributions are much more difficult for professional managers to deal with because there is a single decision or event that can lead the market in two different directions. Will X default? Will the FDA decision be favorable for the company? How will the court rule in this key case that affects the survival of the company? It was largely these circumstances that led to the poor hedge fund and professional manager performance in 2011.

Unimodal return distributions, on the other hand, are far more manageable and much easier for professional investors to deal with. Modern portfolio theory is based on bell-shaped return distribution functions. Managers are well trained to manage risk in such situations and virtually everyone does it well.

What are the risks?
While I believe that equities are poised for reasonable returns in 2012, there are significant risks to the market. In the short term, I agree with Cullen Roche at Pragmatic Capitalism when he pointed out that investors appear to be overly complacent and due for a corrective pullback, a conclusion also shared by Mark Hulbert.

In the medium term,  believe that there are two major macro risks that face the market in 2012. First, there is the risk of a recession in the US, which has loudly trumpeted by ECRI. While the high frequency economic releases have generally been coming in above expectations, which points to a weak but non-recessionary economy, what bothers me is that respected investors who are not permabears, such as Jeremy Grantham and Jeffrey Grundlach, have been cautious.

If the American economy were to move into recession as per ECRI, then we should be seeing its effects now. I would be watching carefully corporate guidance and the body language of management as we go through Earnings Season. Last week, earnings were generally upbeat with the exception of GOOG.

The second major macro risk facing the market is a hard landing in China. While the Chinese economy is showing signs of slowing, the authorities are also taking steps to cushion the slowdown. Most worrying though, is analysis from Patrick Chovanec that indicates that Chinese GDP growth would have been 6.6% had growth from the property sector been flat - which is a brave assumption given the sad state of the property market today. A Chinese GDP growth rate of 6.6% would likely freak out the markets as it is in hard landing territory.

What about Europe?
Conspicuous by absence in my list of macro risks is Europe. I respectfully disagree with John Mauldin when he wrote this week:
As this letter will suggest, I don't think this is the year you want your portfolio in typical long-only funds. There is a lot of tail risk this year coming from Europe.
In the worse case, consider what might happen if Greece experienced a hard default inside the euro, given that the ECB et al appear to be ready to fight the fire:
  1. Greece defaults.
  2. Banks have to mark to market their Greek paper and Credit Default Swaps get paid out.
  3. Banks become insolvent, but small depositors can get their money because of limited deposit guarantees up to X.
  4. Insolvent banks either get merged with strong banks (not many in Europe), get taken over by their sovereigns and restructured into good bank/bad bank (i.e. taxpayers take the hit), or go bankrupt.
  5. Some investors will get hurt, but there will be no mass panic because of ECB liquidity.
  6. The inter bank market would likely freeze up under such a scenario until there is more clarity about which banks live and which die. In the meantime they live on emergency ECB life support.
  7. Risk premium migrate to the sovereign bond market. 
Any crisis will get contained if the ECB prints. The Germans, if they object, will be faced with a choice of a catastrophic failure vs. QE. In the end, I believe that they would choose QE.

This sounds more like a Long Term Capital Management crisis whose effects was contained, rather than a Creditanstalt event that takes down the banking system and set into motion the second leg down in the Great Depression.
Don't worry, be happy
For now, my advice is to relax. Stocks look reasonably priced, barring catastrophic accidents. Even David Rosenberg is sounding somewhat bullish (or at least less bearish) these days:
We have a situation now where the P/E ratio, based on the trailing 12 months of earnings, is a mere 13. That may not be a classic trough by any means, but only 20 per cent of the time in the past quarter-century has the multiple been this low. That is something for investors to consider.
The multiple based on estimated earnings for the next 12 months – the “forward” P/E – is less trustworthy than the trailing P/E because it depends on analysts’ ability to accurately forecast the coming year. But as it stands, the forward multiple is now just a snick below 12.
In the past quarter-century, we saw only one other time when it was this low on a one-year forward basis, and that was the first quarter of 1988. A year later, the S+P 500 rallied 15 per cent.
That, too, is something to mull over.
For now, my Trend Model is showing a neutral reading and I anticipate some short-term choppiness as the market consolidates and digests the recent gains from the October lows. Beyond the short-term choppiness, equities should show some reasonable returns for the remainder of the year.
Don't worry, be happy.
Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.
None of the information or opinions expressed in this blog constitutes a solicitation for the purchase or sale of any security or other instrument. Nothing in this article constitutes investment advice and any recommendations that may be contained herein have not been based upon a consideration of the investment objectives, financial situation or particular needs of any specific recipient. Any purchase or sale activity in any securities or other instrument should be based upon your own analysis and conclusions. Past performance is not indicative of future results. Either Qwest or Mr. Hui may hold or control long or short positions in the securities or instruments mentioned.

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