Investing – The Global Growth Thesis Takes A Rest

The End of QE2

Everybody knows that QE2 ends in June. The only question is, when the market will begin to react. Will the market rally until the last minute? Or will it start to slow down beforehand? I think it’s the latter. Most professionals have already outlined their post QE2 strategies. Many have begun to adjust their portfolios.

This might sound obvious, but there are other points of view that imply a very different course of action. The fundamentalist might say that earnings were very good, the recovery is on track and the investor should hold through the end of the year. Another example would be Jim Cramer, the manic host of CNBC’s Mad Money. After the sharp sell-off in commodities over the last couple weeks, Cramer basically said that it was only hedge funds forced to de-leverage. In his opinion, nothing is wrong with the market, and the investor should “buy, buy, buy” stocks because the economy is good and stocks are cheaper. This implies that the investor should buy the stocks that have been working, because the recent selloff is just a pause in a trend that will continue.

I think an entirely different strategy is in order. We’re at a point where the things that have been working will, at the very least, take a pause for the summer. Some trends are likely to reverse entirely. I don’t think we can just buy more of the stocks that have been doing so well for much of the last 8-9 months.

Low Expectations for Key Sectors in the Summer

To understand the reasons why, let’s break things down a bit. I like to look at some of the leading sectors. If the major sectors aren’t moving, then the market as a whole can’t really move forward.

Financials Financials are the definite dog of the day. They’re lagging the market – significantly. Some would say that the laggard is the most likely to catch up. But if we look at the banks more closely, there’s little reason to be excited about the financials over the next few months. The biggest problem: it’s hard for the financials to make money without loan growth. After all, this is their main business. Across the board, banks had weak loan growth in the first quarter. In fact, reserve releases – reversing the money set aside for loan losses – were a big part of earnings last quarter. Such earnings are “weak”, a result of accounting more than anything else. Also, the banks continue to be plagued by mortgage litigation that they cannot clearly quantify. Finally, Washington has yet to stabilize financial regulation. Many of these issues will be clarified by year-end, but I doubt that we will know much more by the time second quarter earnings roll around.

Could it get worse for the banks? Well, actually, there is a scenario where things could get worse. The uncertainty caused by QE2 could make investors buy bonds. In this case, the longer-term bond yield could fall, causing the yield curve to flatten. Banks make the most money when the yield curve is upward-sloping. They make money on the spread, the difference between the higher longer-term rate and the lower shorter-term rate. When the yield curve flattens, this reduces the spread that banks earn. So if you believe that investors will buy bonds in June because of the end of QE2, banks are likely to have weak second quarter earnings. Under this scenario, you should look to buy the banks in the summer when they are at their weakest and aim for resolution of these issues (loan growth, mortgage litigation and regulation) by year-end.

Energy, Commodities, Materials and Agriculture
These are what are known as the “risk-on” trades – investments fueled by the Fed’s QE2 (because many of these are traded in dollars, and the increase in money supply drives up the price of these things) and the global growth story. Well, in June we will have the end of QE2, so that will slow down the commodities story. Plus, countries around the world are facing inflation and demand destruction from higher input prices. The case most familiar to us is oil: $110 oil (or so) translates into $4-5 gas in the US, which will cause consumers to spend less on many things, including gas. Oil might exceed $110 per barrel if economies around the world are chugging along full throttle, but this is not the case today. Asian markets are tightening, the US is slowing and European is weak and mired in debt problems. That makes it likely if oil rises back to the $110 range, demand destruction will again become an issue and the price of oil will fall back. Many analysts have renewed their call for $120 oil, but I think that this is more likely later in year, as opposed to the next few months. And oil is the example I’m using, but the same dynamics are evident in commodities, materials and agriculture.

Industrials This is the one area that could have a respectable summer. On the one hand, a slowdown around the globe could soften revenues for industrials, but there is no evidence yet that the world slowdown will be sharp or significant. Moreover, many industrial products have longer-term planning cycles. Take for example major investments such as airplanes, trucks, cars and chemicals. The world slowdown is not yet serious enough to cause major cancellations in orders for these products and inputs. So if we look to second quarter earnings, we could expect in-line, but not necessarily exceptional or disappointing revenues from industrials. On the earnings side, industrials could get a bump if (1) they can raise prices; and (2) the cost of inputs – energy, commodities and materials – decline. So if QE2 causes a summer pullback in input prices, industrials could fare well.

Technology Technology is well into a correction. The apparent glut in the tablet space, a slowdown in buying from China and the interruption in parts from Japan have already caused many tech stocks to fall back. Few have managed to come back to or exceed recent highs. Most have seen a lower high – a bearish signal according to the technicians. Renewed, or new demand is needed to get the tech stocks moving again, but not much is expected to happen this summer. There are no major product releases, no major breakthroughs in technology to drive demand. Corporate budget cycles usually lead to tech buying starting late August/September, and the consumer pattern is the same. It’s no surprise, then that expectations for tech are very low for the summer.

The only real case for technology is that it’s beaten up and relatively cheap. With strength anticipated going into year-end, investors may put money into tech this summer just to be in position for the year-end cycle.

This short sector-by-sector review indicates that financials, energy/commodities/materials/agriculture and perhaps technology can be weak during the summer. Unless we get new information that changes things, I think it would be hard for the market to push toward new highs in the summer.

The Macro Picture

Before closing the book on this analysis, let’s take a look at the macro picture and see if it confirms our sector analysis.

Asia, the US and Europe China and the emerging markets are facing inflation and tightening – raising interest rates and bank reserve requirements. This will slow buying of energy, commodities, materials, agriculture and technology. It may also slowdown some of the industrials, but this will depend on the sector and their percentage exposure to these geographies. So far, the tightening seems to be working. Many think (as I do) that China has been in a bubble, but there is nothing to indicate that any kind of collapse is imminent. In the US, rising prices are also creating demand destruction. This, combined with problems in the supply chain due to Japan, has already resulted in reduced estimates for GDP growth. Meanwhile, the Europeans are preoccupied with inflation, debt, and increasingly expensive debt (i.e., rapidly increasing interest rates) for the peripheral countries that have debt problems. All in all, world seems likely to slow down. All indications are that global growth will continue, but perhaps not at the pace anticipated.

The Role of Expectations And so that’s the rub: expectations were already high coming into the year. Expectations are set at the beginning of the year. If we look back, we see that expectations were very high at the new year. The S&P closed 2010 at about 1257, and many called for 1400 or higher by the end of 2011. That’s 11% or more return by year end – nothing to sneeze at by any means. The slowdown caused by the Japan tragedy, European debt fears, China slowing, inflation and demand destruction all mean that economies may fall short of the expectations set at the beginning of the year.

The Change in Thesis

In past articles, I’ve written about market “themes” or “theses” – the idea that markets are operating based on certain beliefs about the economic state of the world. These ideas may reflect reality, but they could also be very inaccurate. Still, markets operate based on these ideas. Some may argue that the sell-off last week was just one big margin call for over-leveraged hedge funds. I’m inclined to believe that last week’s sell off confirms that the theses dominating the market are shifting. The transition has been going on for some time, but as things sell off, this only accelerates belief in the new thesis that global growth is slowing.

The Rolling Correction For the last few years, the market has been highly correlated. Almost all equity assets went up together and went down together. Corrections were sharp, quick and correlated too – much of the market corrected and recovered together. In contrast, this year, we’ve had what I call “the rolling correction”. That is, the market corrects sector by sector over time. Financials corrected first, starting in February and it’s been downhill ever since. Technology was next and corrected over a period of months. First it was the news that sales to China were weaker than expected; then the launch of the iPad 2, which made people realize that other tablet models wouldn’t really sell as well as they had thought; and finally, the disaster in Japan. This caused technology stocks to grind to a halt over a period of months. Industrials actually had very good reports, but over the last couple weeks, two more parts of the market took hard hits: energy, commodities, materials and agriculture; and the high-flying Chinese internet stocks such as Bidu. This begins to knock out the more aggressive hedge fund and “risk on” investors. If you step back and think about it, each of these is a pillar of the global growth thesis, each has been knocked down over a period of several months.

Rotation, But Not Enough Many will note that there has been a rotation out of the sectors discussed above and into sectors such as healthcare (including insurers, pharma and biotech), as well as retail and consumer staples. Money has been moving into these areas, but I don’t think there is anything happening in these sectors that is enough to ignite and raise the entire market. In fact, some of the money coming out of other sectors is going into bonds, and the rise in the TLT, the 20-year bond fund, shows.

So as we enter May, the second quarter and the summer, we can see that the global growth thesis has taken some major hits, and likely need a summer’s rest before re-emerging.

I am long SPY.

In my blog, at www.minglo.com, I will be discussing strategies for the post-QE2 world.

Until next time, sleep well.

Disclaimer. All material presented herein is believed to be accurate but we cannot attest to its accuracy. All trades, patterns, charts, systems, etc. discussed in this article are for illustrative purposes only and are not to be construed as specific advisory recommendations. All ideas and material presented are entirely those of the author and do not necessarily reflect those of the publisher. All readers are urged to consult with their investment counselors before making any investment decisions.

No system or methodology has ever been developed that can guarantee profits or ensure freedom from losses. No representation or implication is being made that using the above approaches will generate profits or ensure freedom from losses. The examples used herein are not intended to represent or guarantee that anyone will achieve the same or similar results. Each individual’s success depends on his or her background, dedication, desire and motivation.
The author may or may not have investments in the stocks or sectors mentioned.

As always, I encourage you to consult your own investment advisers before making any investments. I don’t claim to be right; I can only present you my logic, and I hope you will take the time to do your own homework and decide if you agree or disagree with the arguments presented here. Also, if you really feel like spending some more time on stocks, there’s more on my blog at http://minglo.com/investing/.

Ming Lo is an actor, director and investment advisor. Currently, Ming is a member of the board of Chinatrust Bank USA. He has an A.B. from Harvard College, Cum Laude, and an MBA and an MA Political Science from Stanford University. Prior to going into entertainment, Ming worked at Goldman, Sachs & Co. in New York and at McKinsey & Co. in Los Angeles.