Sunday, October 20, 2013

With Debt Ceiling Debate Out of Way..What's Next For the Market? (An Investment Strategy Update)

Perhaps I was too pessimistic in my prior post to expect a market correction. Stocks hardly experienced a correction at all! The S&P500 and TSX both reached new 52-week highs of 1745 and 13,150 respectively. Investors are cheering over the fact there was a temporary kick the can down the road solution that avoided a U.S. default. Yes, a disastrous default was avoided, but the fight will come up again. Let's all hope Santa gives politicians a merry Christmas so they all can maintain their rationality in the new budget/debt ceiling negotiations in the new year. 

A 11th Deal...Again:


The Reid-McConnell dual did it again. Once again, it was up to the Senate to break the stalemate given the House cannot formulate any reasonable bill.  The deal was extremely favourable for the Democrats given the bipartisan bill re-open the government and provides funding until January 15th without any large changes to the Affordable Care Act (Obamacare) that conservative GOP lawmakers demanded. Also the bill suspends the nation's debt ceiling to February 7th, giving lawmakers a small breathing room of 4 month to come up with a credible deficit reduction plan.  A bipartisan committee is set up to negotiate over the budget, trying to bridge the differences between the House budget and the Senate budget. The deadline is to present a proposal to congress by December 13. 

Damage of Political Bickering:

The GOP's strategy of combining the Obamacare debate into the debt ceiling negotiation backfired. Even senior GOP members like McConnell admitted the strategy was "flawed" in the beginning. Unfortunately, the biggest losers are not those adamant conservative GOP lawmakers. The real losers of the 16-day government shutdown are actually the ordinary Americans that depended on the government. Most economists estimate that there was a direct 0.2% GDP hit because the loss wage income of the 400,000 furloughed government workers. There could be another 0.3-0.4% GDP hit in the fourth quarter because of indirect impacts, i.e. tourism/travel businesses saw a huge decline in customers due to the shutdown of many national parks and government sites. Adding both the direct and indirect impacts, there could be a 0.5-0.6% drag on the fourth quarter GDP. Prior to the government shutdown, the U.S. economy was expected to grow at 2.6% in Q4 (Q1 growth of 1.1% and Q2 growth of 2.5%). Therefore, the 16-day government shutdown would reduce Q4 GDP to approximately 2%. 

Here is a million dollar question: If the economy just experienced a slowdown, why is the equity market rallying to new highs? The simply answer is the Fed. Given a 0.5-0.6% cut in GDP in Q4 and the fact that the Fed policymakers are literally flying blind (important data such as non-farm payrolls, inflation, industrial production, housing reports were all suspended due to the government shutdown), it is likely there may not be any further tapering talks for the remainder of the year. According to a Bloomberg survey of Wall Street economists, the Fed is not expected to taper until March next year, a complete change in opinion since August when the Fed was expected to taper last month but did not. The expected path of QE3 is completed altered and additional stimulus is likely to provide further boost prices of risky assets. As former Citigroup CEO Chuck Prince used to say, "as long as the music is playing, you gotta get up and dance"

Equity Outlook:

The outlook for equities is positive for the next few months (up to New Years Day), although the author is still slightly cautious given current valuation. The S&P500 is valued at 16.6X trailing earnings and 14.5X forward earnings. The long term average for trailing earnings is 16.4X (50 year) and 14X (20 year) for forward earnings according to Bloomberg data.  Although valuation may look high, there is no doubt that the current least path of resistance for equities is up, meaning further gains ahead. Moreover, equities tend to gain from late-October to December based on historical seasonal trends with December being the best month for stocks. Finally, stocks current have positive price momentum and that will trigger further buying to support the current advance.  A combination of seasonality, positive momentum, and monetary stimulus all point to a positive outlook for equities for the remainder of the year. 

In my July Investment outlook report, I expected the S&P500 to finish 2013 at ~1625. Because tapering is delayed and the debt ceiling problem is avoided, I now expect the index to finish around 1720-1770, a valuation based on expected earnings of $122 in 2014 and a 14-14.5X forward multiple. Although the multiple is slightly higher than the average 14X, I expect the positive investor sentiment and the high level of monetary stimulus to justify recent multiple expansion. The index rally this year was 70% attributable to multiple expansion and only 30% to actual earnings growth. Given earnings is expected to grow only 8% while revenue is only expected to grow 5% this year, a 24% rally (YTD) in the index is not justified purely on fundamentals alone. The search for yield  has force many investors, small or large, to invest in riskier assets like equities in order to fulfill their expected returns requirements. 

Nonetheless, there are slight positives that can at least maintain the current price momentum to year-end. First, according to Factset, out of the 97 S&P500 companies that reported Q3/2013 earnings, 53% reported  sales above consensus estimates. That is slightly better than 40-50% rate in prior earnings seasons. Top line sales growth is paramount to further earnings growth. In addition, profit margins is near 2007 highs.

Sector-wise, I still favour cyclical sectors like financials (banks benefit from steeper yield curve and insurers can benefit from higher interest environment. Author likes MFC and IAG), industrials (GM, F, UNP), energy (downstream refiners like VLO looks attractive given the low crack spreads), and technology (look for the cash cows and good ROIC like CSCO). Despite putting a underweight outlook on materials in July, the author feels many names in this space are becoming undervalued such as AGU and YRI/AUY. 


FICC Asset Outlook: 

The outlook FICC (Fixed Income, Currencies and Commodities) remains relatively unchanged since my July Investment Outlook Report. I am keeping most of the expected price targeted unchanged such as the year-end target for 10-year treasuries at 2.8%-3.0% (despite a huge change in tapering expectation!).  A slight change would be a less favourable outlook for the U.S. dollar given delayed tapering,  which is positive for commodity currencies like the CAD and AUD.


Disclaimer: 
This piece is for information purposes only. The list of stocks suggestions provided only serve to provide readers with ideas that they can further conduct research on. The author is not responsible for any losses readers incur by buying any names suggested. 

Out of the names suggested, the author owns a large stake in MFC

1 comment:

  1. Kenny ~ Excellent article on "BBRY" in Seeking Alfa.....I agree with you 100%. Very well put! I'm also a long term holder of "BBRY" and I think we'll enjoy the ride....Happy trading to you.........the nurturechef (Joyce)

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