Pragmatic Capitalism

Practical Views on Money, Finance & Life


Morgant Stanley’s European strategy team (headed by the always prescient Teun Draaisma) is out with their 2010 strategy commentary and they see substantial headwinds ahead of the equity markets and ultimately a negative year for 2010 (Credit Suisse has some similar concerns though they are more near-term).  Draaisma believes the current momentum and optimism could send markets 10% higher, but he ultimately believes the withdrawal of stimulus will sap the market of its strength and instill doubts about 2011 growth.  Draaisma says the markets will decline 5% in 2010 and could fall as low as 13% during the year:

“The withdrawal of stimulus will be a very dangerous period for the economy and markets.  We expect a consolidation in markets associated with the start of tightening and its impact on 2011 growth.”

For now, however, the market is still in the sweet spot.  The bull market should continue for three reasons:

Sweet spot until tightening bites. We expect the cyclical bull market to continue for three reasons –

  • First, we believe we are at the start of an earnings growth cycle (we forecast 20% 2010 EPS growth, while our earnings growth leading indicator predicts 38%).
  • Second, equity valuations are still attractive versus rates (2010 IBES DY 3.5% versus 10-year US bond yields of 3.5%).
  • Third, sentiment is not ultra-bullish yet (AAII bulls minus bears, three-week moving average of +4).

We see 9% upside to our bull case of a mid-cycle multiple on mid-cycle earnings of 15x 12% ROE. That equates to 1200 on MSCI Europe. Above and beyond that ‘normal’ level, we think the risk-reward would deteriorate rapidly as this is unlikely to be a normal cycle.

But Draaisma isn’t getting overzealous here.  He doesn’t see the rationale in getting overly aggressive in an attempt to capture the last 10% of a 70% rally when the downside could be greater.  Draaisma believes market gains will be more difficult going forward and therefore the risk/reward of the current market is substantially more negative than it was a few months ago.  He remains neutral on equities, but favors stocks over cash and bonds:

Market to be broader and slower from here. We do think it likely that the rally will slow and broaden out, for four reasons.

  • First, European equities have just enjoyed the biggest six-month rally ever, and the market is the most overbought since 1998.
  • Second, our analysis suggests that multiple expansion is over when earnings trough, which is about now.
  • Third, some sector laggards such as Oil, Pharma and Telcos have now become under-owned and cheap on our models.
  • Fourth, ISM orders less inventories have peaked, which is followed by up markets but a broad sector mix, usually.

Ultimately, the stronger economy and return of job growth will lead to tighter monetary policy and reduced government stimulus.  Draaisma believes this will hamper the rally as investors look towards 2011 and the potential return of low growth.   The tightening phase of the secular bear market will likely look something like this:


So how do you time the tightening phase?  Draaisma has a checklist.  4 of the 10 criteria have already been met with the remaining 6 likely to be met in Q1 & Q2 of 2010.  That would likely be the time to begin getting very cautious.


For now, however, Draaisma remains neutral (50% weighting) on equities with a 10% cash weighting and a 40% bond allocation.  Draaisma’s favorite sector is energy followed by materials and staples.  He is also overweight healthcare as valuations and growth remain attractive.  He recommends underweights on utilities, consumer discretionary, financials and tech.

Cullen Roche

Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC.Orcam is a financial services firm offering asset management, private advisory, institutional consulting and educational services.He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance and Understanding the Modern Monetary System.
Cullen Roche

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