Smoke and Mirrors

Illusion #1: Nominal Returns
With today’s close, the S&P has soared 42% off of its most recent bear market low of 666 set in early March. However, during the same period, the dollar index has plummeted 11.4% from 88.5 on March 6 to 78.4 on June 2. So in real dollar terms, the S&P is up just over 30%. In my prior post, I stated that the S&P could run another 5% to 920 back when it was trading at 877. As of today, the S&P is up 7.7% from its May 1 close, surpassing my target by 2.7%. Should I admit defeat and move on? Not quite as the dollar index has shed 7.2% over the same period, resulting in a real dollar gain from May 1 – June 2 of only .5%. In other words, the S&P must pass 980 holding the dollar index constant at today’s levels to violate my original call. All of the gains enjoyed over the past month are an illusion, only making up for the loss in the dollar’s value.

The devaluation of the dollar artificially improves equity performance given that real returns over the past month were less than 1%. America thinks in nominal terms, and the shrewd policy makers have developed an uncanny ability to pull the wool over the general public’s eyes. The average person watching TV every night sees a continuous stream of positive headlines and concludes that the economy seems to have turned the corner. All the while, national gas prices have soared over 50% in 2009 to a national average of $2.52/gallon on the back of lower refinery production and the weaker greenback. Note that each 1 penny rise in the retail price of gasoline costs American consumers $1B a year. Oil priced in gold will fall sharply once this most recent round of speculation reverses by mid-summer. In general, I believe that commodity prices will crash again as people realize that the anticipated economic recovery will not take place.

Illusion #2: Second Derivative Data
The main driver underlying Monday’s 2.6% rally was the better than expected ISM index of 42.8 against the consensus estimate of 42. Any reading below 50 still represents contraction, although new orders for the month rose above 50 for the first time in 17 months, which is the main data point that equities rallied on during Monday’s session. The Chinese manufacturing survey, also released Monday, showed growth for the third straight month and helped set a positive tone for trading in Europe and the U.S this week. I fully expected this economic uptick because of all the money that has been thrown at economies by governments worldwide. These stimuli coupled with second derivative economic statistics have and will create the illusion of improvement over the next several months.

Second derivative means the change of the change. For example, house prices are often analyzed by the change over the prior year or month. So if home prices fall 20% in May over the prior year, this means the real change from the peak is actually worse (maybe 30% lower than 2006) since home values had already started falling as of May of 2008. Eventually, the rate of decline will slow or show slight improvement because the comparisons will be made against depressed economic data. Markets are fixated on this second derivative data, but it only serves as noise over the long run because the trend will only continue lower. The talk by year end will shift from this change to fears of a double dip recession that will lead to the next leg down in the equity markets.

Illusion #3: The Emerging Market Mirage
The biggest smoke screen that I have seen recently, however, is the emerging market mirage. Many strategists believe that the Asian growth economies are going to lead the global economy out of this recession. As a result, many firms and individuals have emerged advocating full investment in foreign markets in order to shield investors from the low growth developed economies.

Chinese, South Korean, and Indian equities have sharply outperformed their American and European counterparts during the most recent bear market rally. The prevailing thought by money managers blindly throwing money into these markets is that this is where the growth lies during a potential economic rebound. This school of thought is flawed for several reasons:

1) Contrary to popular belief, these economies benefited from much of the fake growth that took place over the past decade fueled by cheap credit. As a result, the deleveraging process that still needs to unwind will impact these markets significantly.

2) These economies remain heavily dependent on exports. Thus, the decoupling theory, or belief that their domestic economies can more than offset the reduced demand in developed economies is ludicrous. Many U.S. equity bears continue to shift funds into emerging markets thinking that those economies have or will soon decouple from the U.S. economy. They point to the outperformance of the Chinese Composite, the Hang Seng index in Hong Kong and the Indian Sensex as these indices have outperformed U.S. equities during the most recent bear market rally. They conveniently exclude the fact that these indices had fallen much more sharply than U.S. indices as of November 2008. These strategists have concluded that China and India, sporting populations well in excess of 1B people each (or roughly 37% of the global population) will easily step in and replace the purchasing power of the U.S. I agree with this school of thought over the long term, however, it took decades for this relationship to develop, and it will not unwind over the course of several months.

At first glance, it is difficult to argue against the potential purchasing power of over 2B people in China and India, but of China’s 1.3B people, 130M live on less than $1 a day. Additionally, 8% of the Chinese population lives below the poverty line. Although Chinese GDP for 2008 amounted to $7.8T, 40% of its GDP was based on exports to the U.S., Japan, South Korea, and Germany. Unlike U.S consumption, which accounts for 67% of the economy, only 36% of the Chinese economy is based on consumption. This does not even begin to address the huge gap between the rich and poor in both China and India as their respective middle classes attempt to establish themselves. People also cannot ignore the practical environmental limitations of having over 2B people try to live an American lifestyle.

Those clamoring to gain emerging market exposure will see their portfolios decimated during the next wave down in the late summer and early fall. Expecting these economies to replace American consumption is akin to asking a high school student to support a family with their part-time mall job after both parents have been laid off. China and India will grow, but not until they have been weaned off the Western economies.

Given my thoughts above, I will highlight several key concepts underlying my current investment strategy:

1) I do not expect equity markets to pull back meaningfully until this fall, but I believe that certain names within the consumer cyclical, technology and financial sectors in the U.S. are now attractive shorts. For example, Goldman Sachs, Amazon, Google, and Apple all have rich valuations and have significant downside risk once investors realize that the economic recovery will not take place nearly as soon as expected.

2) If yields in the treasury market continue to rise, this will have an immediate and sharp impact on stocks. The yield on the 10-year note has already risen to over 3.6%, and that is with the Fed in the market purchasing treasuries. Investors (mainly China) continue to reallocate funds from longer dated notes to short term bills because of inflation concerns. This has resulted in widening spreads between bills and notes although mortgage rates remain artificially suppressed because of government controls and subsidies.

3) Starting in August, I will begin shorting basic materials and related stocks such as Rio Tinto. I decided to delay this strategy because commodities still have room to run as people continue to rotate out of the dollar and into hard assets.

4) I will short emerging markets in late August because they are not the safe haven that everyone assumes.