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DEEP THOUGHTS FROM DAVID ROSENBERG

Rosenberg is out with a real gem this morning.  I’ve attached parts of it for readers with my own rambling commentary inbetween:

THERE ARE FOUR DIFFERENT FACTORS THAT DRIVE THE EQUITY MARKET

1.Technicals

2.Fund flows/Market positioning

3.Valuation

4.Fundamentals

Let’s examine each one at the current time.

1. With regard to the technicals, they are uber-bullish. Not only has the A-D line broken out to the high side, but the S&P 500 yesterday broke above the intra-day high of 943 set back on January 6, not to mention taking out the 200-day moving average. The ultimate retest will have to wait another day. This market is at risk now of melting up; and, as I said before when I was keeping an open mind regarding the longevity of this rally, notwithstanding my skepticism, if credit spreads, Libor, the Ted spread and commodity prices could all go back to pre-Lehman levels, why couldn’t the S&P 500 too? That would mean a possible test to the high side of 1,200, believe it or not. That is an observation, not a forecast, by the way. Back when we hit that level last fall, it was a glass-half-empty feeling of being down 20% from the highs; this time around it is a cause for celebrating an 80% move off the lows! The S&P 500 is now up more than 4.0% for the year; the Nasdaq, which was the first of the major averages to break above the 200-day m.a., is up 16.0% year-to-date. The Dow is roughly flat.

As I’ve said before charts are lines on paper – they are only as good as the fundamentals that back them.  While the 200 day moving average is certainly important it is viewed as much as a sign of resistance as the line that differentiates bull and bear markets.  We would have to see a substantial move higher followed by a retest of the 200 day WITH coincidentally strong fundamentals to justify any such technical move.  While the trend is your friend I am still of the belief that we are at a major testing point for this rally – especially with the financials and housing stocks failing to break through their 200 day moving averages.

2. The rally seemed to have stalled out on May 8 and for the next three weeks, all the market seemed to do was range-trade between 880 and 920 on the S&P 500 … until yesterday. The initial source of buying power in March was the dramatic short-covering and pension fund rebalancing. Then in April the retail investor became enamoured of the ‘green shoots’ and found $12 billion of money to put into equity mutual funds (only the second net inflow in the last year, by the way). And, as May morphed into June we likely have started to see the capitulation among institutional portfolio managers, who collectively shard by cautious view.

As the just-released Barclays survey of some 600 fund managers revealed, fully 60% had been viewing the move off the March lows as a bear market rally, less than 5% bought into the V-shaped recovery forecast; and only 9% were fully invested. The risk of being pressured to chase performance is high, and along with that, the odds of a further melt-up, all the more so with the technicals being pierced in resounding fashion.

One final item to note on Mr. Market; it is not a shoe-in that the stock market is about to stay on this one-way ticket north. Two things happened yesterday that is worth noting. First, the late-day round of profit-taking left the S&P 500 at 942.87, which was below the intra-day high of 946.0 reached back on January 6. And something very strange happened in yesterday’s session, which is that the VIX index rose 3.8% even as the S&P 500 rallied 2.6%. Not only has the VIX index, in the past, fallen over 95% of the time that the stock market advances, at no time in the last seven years did a 2%-plus surge in the S&P 500 coincide with an increase in vol … until yesterday.

This is a concern Jeff Saut reiterated on his European tour.  Performance chasing certainly becomes a concern as the indices move into positive territory and money managers realize they are losing the relative return game….

3. The global trailing P/E multiple has surged five points during this rally to 15x. So this market is far from cheap. Let’s look at the S&P 500. A classic mid-cycle multiple is 15x, so basically the market is pricing in $63 of operating earnings. That is being generous because based on where the corporate bond market is trading, the fair-value multiple is around 12.5x, which then means that equities are discounting $75 of earnings, which we would not expect to see until 2013 at the earliest. (A 15x multiple is also rather generous when one considers that we now have an economy where large chunks — autos, insurance, mortgages, banks — are at least partially owned by the government.) Look at this way — we are going to be hard-pressed to see operating EPS much better than $43 this year. A ‘normal’ first-year earnings bounce is 20%, and again this is being generous, but that would leave us with $52 EPS for 2010.

We give that prospect very little chance of occurring, and we have some difficulty with the stock market going ahead and pricing in an earnings profile that is likely four or more years away from occurring. Are we going to be back pricing in end-of-cycle or recession earnings this time next year at the rate at which investors are discounting the future. There may be upside to this market based on factors (i) and (ii) but we remain concerned about its longevity because at some point, post-bubble earnings realities in a deflationary top-line environment (nearly two-thirds of S&P 500 companies missed their revenue targets in Q1) will re-emerge on the front burner.

I am of the mindset that using the PE ratio to value a market is a terrible flaw in analyzing any market.  An asset with above average future expected growth will always be viewed as valuable whether it is “expensive” or not.

4. The economic fundamentals are open for debate, to be sure. The same consensus and equity market that couldn’t see the recession coming two months before it did surface back in 2007 are now supremely convinced that the recession is over and that economic renewal has begun. This has gone even further than ‘green shoots’. But what provided the real spark yesterday was the ISM index coming in at 42.8, up from 40.1 in April; as with the consumer confidence surveys, this was the best result since last September when Lehman collapsed. What caused the excitement was that the folks at the ISM claimed that at 41.2 on the business diffusion index, the recession comes to an end.

There is no doubt that we are seeing improvement from very depressed 4th quarter levels.  But there is also no doubt that the overall de-leveraging weakness is still very much with us.  While we can see strength in pockets and in short stints it is very unlikely that the U.S. economy sees a substantial rebound based on the enormity of the deflationary headwinds and overall debt trends.  We might print our way back to growth, but then all we’ve created is an inflationary environment where the dollar gets slaughtered and inflation adjusted returns remain below average.

WISHFUL THINKING

Maybe that is true in a classic manufacturing inventory recession, but this was a downturn led by asset deflation and a credit collapse. Let’s go back to when the recession began in December 2007 and you may be interested to know that the ISM was 49.1. The month before LEH collapsed, oh, only eight months into the recession, the ISM was sitting at 49.3. So somehow, we are to believe that the recession has ended because the ISM broke fractionally above 41.2. Mercy. This was not a manufacturing-led recession — the factory sector was an innocent bystander in this de-leveraging cycle.

Moreover, within the ISM survey details, what we see is that 28% of businesses reported any growth at all last month, compared with 39% in May 2008 — again, when the recession was into its fourth month. Somehow, with fewer industries expanding now compared to then, the recession, we are told, is done. If only it were true.

No doubt there was good news in the ISM orders component (it rose to 51.1 from 47.2 — best level since December/07) and the customer inventory segment was at its tightest level since April/08. But it is hard to believe that orders will continue to expand in the absence of a recovery in consumer sales; and that is going to require an end to the multi-month wave of job losses. What was dismissed, for some reason, from the ISM report was that the employment component dipped to 34.3 from 34.4 — when the recession began, it was sitting at 48.7. Fascinating way to the end the recession — ISM employment 14 points lower than when the downturn officially began.

Not only must employment bottom before the recession ends, but so must consumer spending. So what we saw yesterday morning that was interesting was that the combination of the tax relief and benefit increases gave personal income an artificial $110 billion boost (at an annual rate) in April, and even with that stimulus, consumer spending still contracted $5½ billion or 0.1% on top of a 0.3% decline in March. Wages and salaries in the private sector contracted $1.3 billion, the eighth decline in a row totalling a cumulative $160 billion loss. As with so many other parts of the economy (mortgages, autos), the only factor holding up household incomes is the government.

The really big story is that the fiscal stimulus is assisting in the household balance sheet repair process, but is not really doing much to spur consumer spending — highlighted by the rise in the personal savings rate to a 15-year high of 5.7% from 4.5% in March and zero a year ago — never before has the savings rate risen so far over a 12-month span. Note that the post-WWII high in the savings rate is 14.6% and that is where I believe we are heading. Despite the conventional wisdom, this is highly deflationary. For a very good ‘take’ on how spending behaviour is changing on a secular basis, see Americans Get Even Thriftier as Fears Persist on page A2 of the WSJ. While street economists are consumed with ‘green shoots’, which is just noise in a downward spending trajectory, I found what the economist from John Hopkins University (Christopher Carroll who specializes in consumer behaviour) had to say in the article very interesting.

In real terms, consumer spending was down 0.1% after a 0.3% drop in March and points to a moderate contraction for the current quarter. Remember that consumer spending was also marked down in the revised Q1 report to 1.5% at an annual rate from 2.2%. Still no evidence of much in the way of ‘green shoots’ here outside of improvement in the second derivative.

Rosenberg explains the long-term troubles of a de-leveraging recession better than I ever can.

We are not as bearish on the stock market, at least over the short-term, with the S&P 500 breaking its 200-day moving average. As we said, there is the risk of a melt-up as portfolio managers play catch-up. After seeing housing starts collapse 13%, core capex orders slide 1.5% for two months in a row, jobless claims pierce the 600k mark for an unprecedented 17 weeks in a row, organic personal income drop for eight months running and back-to-back declines in retail sales with little sign of a turnaround in the weekly May data-flow, it stands to reason that this is an equity market that is extremely forgiving and resolute in its belief that the recession will give way towards sustainable positive growth starting next quarter. We say this with the utmost of humility, but the onus, indeed the pressure, is now squarely on the bears.

The first quarter was a write-off for GDP and the second quarter is going to show a contraction of between 2.0% and 4.0% at an annual rate — practically every economist has this in their forecast. The key is the third quarter and the reality is that the debate will not be settled until we have a good two months worth of data to glean at, which means that this rally could well be extended through the summer; after a 40% rally from the lows, that is certainly a possibility. As for bonds, well, as with equities the technicals have been pierced and the next level of support on the 10-year T-note yield is 4.11%.

However, long-term, we believe that the U.S. economy is in a gigantic mess and that risk-taking in the stock market is not going to be rewarded on a sustained basis. We continue to hold the view that the stock market, which peaked in 2007 just two months shy of the most intense recession in 70 years, is vastly overrated as a forecasting device and we strongly believe that portfolios will need to be cash-generating machines.

If the portfolio isn’t providing steady income, the return for investors is going to be extremely minimal or even negative. So obviously bonds will be playing a huge role — Treasuries and Canadas at current levels offer a significant inflation-adjusted yields and high-grade corporates still look attractive despite the ongoing compression in spreads. Within equities, we hold to the view that investors should focus on strong dividend-payers and stable cash flows.

Great stuff from Rosenberg.

Source: Gluskin Sheff

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