June 1, 2009

Mixed Messages on Earnings and Consumer Health

Searching for Alpha, June 2009

What's the most likely direction of the markets in the next thirty days? As my family and I prepare for our departure on June 6th for an extended family trip, I find myself wondering where the equity and fixed income markets will be trading when we return later in the month.

There are a number of topics on people's minds right now. First, there is some concern that U.S. government debt will continue to drop in value. I am certainly concerned about this, but my opinion is that Treasury bonds are significantly oversold. The recent seven-year note auction went well, and 10-year rates at 3.73% are still low by historical standards. My view is that bonds will rise in the short term, and will most likely be accompanied by a modest drop in stock prices. Converse to fixed income, equities have gained significant ground and are probably a bit ahead of themselves. In the medium term, we will likely reduce longer-term Treasury positions, but not for another month or so.

More specifically on the equity side, corporate balance sheets remain healthy, the economy is rebounding, and inventories are low, all of which are good signs for earnings. Unfortunately, the health of the consumer is appreciably less bullish. Household debt levels are still high, and expectations for increases in consumer spending are at best modest. I think equity prices will continue to rise but the summer doldrums are upon us, leading me to expect a lower stock market in late June.

One of the better performing sectors in 2009 are senior loan funds. In the past six months, the closed end funds that hold these securities have enjoyed 35% gains. Loans have become a sort of proxy for high-yield debt in the recovery, although unlike junk bonds, the interest rates on loans adjust higher with the general interest rate environment.

To illustrate my point, it's clear that in the recent higher rate environment, loan funds have not been adversely affected, which indicates that if rates ratchet up these returns may continue.

The so-called "natural buyers" of loans (i.e., banks and leveraged vehicles such as collateralized loan obligations) have disappeared, only to be replaced by retail investors, mutual funds, and other market participants. There could indeed be further upside remaining in these positions.

Another issue that has received considerable press is the downgrade of Britain's economic outlook to "negative" from "stable" by Standard and Poor's. There is no doubt that England has credit issues. As unemployment and other payments have risen, tax revenue has fallen. Current debt levels are about 50% of GDP; a ratio of 100% is "incompatible with a triple-A rating," according to S&P. Comparatively, the ratio for the U.S. is about 35%.

As low as the odds are of a British downgrade, the likelihood that the U.S. would see a similar fate is even more miniscule. As the world's leading currency, the U.S. has far greater latitude to increase debt simply by printing more currency. This can't go on forever, and at some point the money supply must contract. The trick is to keep the printing presses rolling long enough to increase economic growth, but not too long for inflation to be a problem. This is a delicate issue, but controlling monetary supply is far easier than adjusting interest rates. Let's hope the current Administration is up to the task.

The Monthly Index Report for May 2009

Index

May-09

QTD

YTD

Description
S&P 500 Index*

5.3%

15.2%

1.8%

Large-cap stocks
DJIA*

4.1%

11.7%

-3.1%

Large-cap stocks
Nasdaq Comp.*

3.3%

16.1%

12.5%

Large-cap tech stocks
Russell 1000 Growth

5.0%

15.0%

10.3%

Large-cap growth stocks
Russell 1000 Value

6.2%

17.6%

-2.2%

Large-cap value stocks
Russell 2000 Growth

3.9%

19.5%

7.9%

Small-cap growth stocks
Russell 2000 Value

2.1%

18.3%

-4.9%

Small-cap value stocks
EAFE

12.0%

26.5%

9.0%

Europe, Australasia & Far East Index
Lehman Aggregate

1.1%

1.6%

2.6%

U.S. Government Bonds
Lehman High Yield

6.7%

19.6%

26.8%

High Yield Corporate Bonds
Calyon Financial Barclay Index**

0.6%

-1.2%

-3.5%

Managed Futures
3-mo. Treasury Bill***

0.0%

0.0%

0.1%

All returns are estimates as of May 29, 2009. *Return numbers do not include dividends.

** Returns are estimates as of May 28, 2009.

Ben Warwick is CIO of Memphis-based Sovereign Wealth Management. He can be reached at ben@searchingforalpha.com.

Reprints Discuss this story
This is where the comments go.