Tuesday, October 23, 2012

Market is short-term bullish, long term cautious

Over at VIX and More, there is an excellent discussion of the contango observed in VIX futures, i.e. upward sloping implied volatility curve as time extends. MarketSci also followed up with a terrific animation of how the VIX contango has developed over time. Here is the key takeaway:
The important takeaway is not necessarily how strong contango is today, but how consistently strong contango has been this year (which is why 2012 shows as such an outlier in V and M’s chart).
One conclusion to be drawn from the term structure of VIX is that Mr. Market is short-term bullish, but longer term cautious.

What happened with Caterpillar?
A case in point is what happened with Caterpillar (CAT) yesterday. CAT is an important bellwether of the global capital equipment sector as it operates all over the world. The company reported earnings before the opening bell yesterday. It beat earnings estimates, but missed on sales estimates and lowered its forecast for 2012. Here is the statement [emphasis added]

We now expect 2012 sales and revenues to be about $66 billion and profit in a range of $9.00 to $9.25 per share. The previous outlook for sales and revenues was a range of $68 to $70 billion with profit of about $9.60 per share at the middle of the sales and revenues outlook range.

The decline in the sales and revenues outlook reflects global economic conditions that are weaker than we had previously expected. In addition, Cat dealers have lowered order rates well below end-user demand to reduce their inventories. Production across much of the company has been lowered, resulting in temporary shutdowns and layoffs. Lower production will continue until inventories and dealer order rates move back in line with dealer deliveries to end users. The reduction in the profit outlook is in line with the lower sales and revenues outlook, partially offset by the gain on the sale of a majority interest in our third party logistics business.
Looking out to 2013, they see continued growth in the 2H of the year. In other words, it's a-hope-and-a-prayer growth forecast with growth backloaded in the forecast period:

From an economic standpoint, we are expecting slightly better world growth in 2013 with modest improvement in the United States, China and most of the developing world, but continuing difficulty in Europe. Based on our economic forecast, our preliminary outlook for 2013 is for sales and revenues to be about the same as 2012 in a range of up 5 percent to down 5 percent.

"We are taking a pragmatic view of 2013—we're not expecting rapid growth, and we're not predicting a global recession. At this point, we expect 2013 sales will be similar overall to 2012, but with a slightly weaker first half and a slightly better second half. While machine deliveries to end users have continued to hold up, our sales will probably remain relatively weak early in 2013 as dealers are likely to continue reducing inventories. When expected dealer inventory reductions level off, and easing actions by central banks and governments around the world begin to improve economic growth, we expect our business will begin to improve. While there's reason for optimism, and we're not expecting a global recession in 2013, we are prepared and stand ready to take action no matter what happens to the global economy," Oberhelman added.
This is a rather ugly outlook from a global bellwether. You would have thought that the stock (and the stock market) would have sold off in the wake of these statements. Well, it did at the open, but CAT recovered to rally throughout the day and finished the day on a positive note.

What's going on?

My inner trader tells me that when a stock or a market rises on bad news, the negatives have already been discounted in the price, which is bullish. Indeed, the conclusion from my last post (see Bearish tripwires) is that intermediate term declines generally do not start with such negative sentiment, outperformance of cyclical stocks and positive momentum from measures of risk appetite.

My inner investor tells me that such uncertain outlook from a global capital equipment bellwether like CAT is a fundamental sign to be cautious.

That's exactly the same message we are getting the VIX term structure, short-term bullish but long term cautious.

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.


Anish said...

I also find it interesting that 10yr treasury yields are rising even on days when the market falls or is flattish, like yesterday.

Ross Halburton said...

Humble student, go back to basic school. Learn good better.

Anonymous said...

Unfortunately, CAT is trading below the close on earnings day - marginally but the fact that there has been NO follow through suggests that the move one earnings day is not of strong conviction.

There is absolutely NO reason to remain bullish. Declining earnings in an environment where profit margins have been boosted to record levels on unsustainable deficit spending and markets near all time highs are NOT the hallmarks of the beginning of a secular bull market. I'm sorry come again. The risk reward to remain on the long side is low and not unlike the peaks in 2001 and 2007.