Guest post from I. Bernobul, Esq.
The S&P 500 Index has sold off 5% since February 18 when investors finally got the cue after stage three of the Arab uprisings that had begun with Tunisia in December before moving to Egypt and then to oil producing Libya.
The price of oil shut up to $94, enough to get economists attempt to compute the likely impact on CPIs and discretionary spending around the world.
On January 28, my esteemed contributor Denis Ouellet wrote YELLOW FLAGS ON EQUITIES arguing that
From a valuation standpoint, the Rule of 20 continues to point to 1500 on current trailing earnings, for a 15-20% upside potential to fair value. This remains a good target for this year. However, the risk of a technical correction towards the 200 day m.a. is not insignificant, skewing the risk/reward ratio and raising a yellow flag for the shorter term.
This is a good application of the “margin of safety”, useful even (especially) when things are looking reasonably good on the economic and financial fronts. Prudence dictates to constantly monitor the risk/reward ratio and balance one’s risk exposure accordingly, even though (especially when) story tellers are sounding good. Do the math first, then check if there is a credible story to support the math.
Not really a black swan, not yet at least, the Arab uprising appeared more like a groundhog springing out of its desert hole. Markets often trip on groundhogs. Known and unknown unknowns are groundhogs. They populate the investment underground but nobody really knows where they are and if they will pop up.The key to groundhog protection is the risk/reward math and the constant application of Donald Rumsfeld’s “known unknowns” thesis (remember, he was Defense Secretary).
Groundhog day is officially February 2nd but investors saw theirs on the 22nd this year.
When Denis waved the yellow flags, the S&P 500 Index was 1285. It rose to 1350 before tripping on the Arab groundhog. The risk/reward ratio is simply back to the uncomfortable level of 15-20% upside against a 10% downside to its 200-day moving average if one looks for a decent potential stopper on a downslide.
But many more groundhogs have appeared lately. It seems wise to list them and assess their potential damage. Some look like real game changers. With so many groundhogs around, many of which potential game changers, equity markets will be tempted to keep some discount to fair value.
MIDDLE EAST: A potentially lethal known unknown. Libya could be followed by Yemen, Bahrain, Syria, not to mention Iran and Saudi Arabia. At a minimum, oil markets will keep a high risk premium but nobody should neglect the risk of much, much higher oil prices. A potential major game changer.
JAPAN: What will the cost be? $200 Billions, $400 Billions? How financed? The government debt/GDP ratio of over 200% has already pushed the envelope on solvency.
FOOD PRICES: Most food commodities have exploded in the past 6 months. We can debate whether it’s the weather or whether it’s the wealthier Chinese and other Asian folks getting fatter on Western eating habits. The fact is that food prices have jumped and there is a decent probability that food inflation will be high enough for long enough to seriously eat into consumer discretionary spending across the world for the rest of 2011 and possibly well into 2012. Gas and food prices may not be part of core CPI, but they are clearly part of most people’s core weekly expenditures. The lower one’s income, the more core these items are in their budget.
CORE INFLATION: Ben Bernanke and the happy IPad-owners Fed academics argue that monetary policy should focus on core CPI which is not problematic at this point. The way I look at it, they should look again.
Pimco’s Mohamed El-Erian sums it up nicely:
The reality and uncertainties of a demand shock would, in themselves, act to reduce inflationary expectations. In monetary policy terminology, the demand destruction would cause headline inflation to converge down to a low and well-behaved core inflation level.
But,(…) the demand shock is being accompanied by a supply shock which has the opposite effect. Indeed, the longer the persistence of supply disruptions, the greater the risk of core inflation converging up to the more elevated headline inflation rate.
THE END OF QE2: June 30, 2011 is D-Day. What will happen to interest rates, long and short? Will it end then or will they extend it, and why would they? Double dipping risk? See READY FOR D-DAY?.
INTEREST RATE INCREASES IN EUROPE: The ECB’s Bernard Trichet does not spend much time on the core CPI debate. The ECB’s mandate is one sided, inflation minded and German written. European interest rates will be rising pretty soon. By how much and how quickly? Equity markets can often cope with rising long term rates but generally dislike rising term rates. Can Europe’s economy withstand rising short term rates? Sovereign debt risk?
We could soon find ourselves in a peculiar situation where interest rates will be rising everywhere!
UK ECONOMY: Meanwhile, the UK economy is already slipping under austerity measures that Americans should get prepared to live through.
CHINA: Chinese authorities are fighting another inflation bout. Can they succeed without a significant economic slowdown? See MORE SIGNS OF WEAKNESS, INFLATION IN CHINA’S ECONOMY.
CORPORATE PROFITS: We can talk QE1, QE2 and other fiscal stimuli etc., the name of the game for equities is PE x Profits. In case you have not noticed, corporate profits have more than doubled since early 2009 and are only 9% shy of their 2007 record level of $91.47. Why should we be so surprised that the S&P 500 Index would be trading 15% below its 2007 peak? However, profit margins are very high and threatened by rising costs when the economy has yet to display solid and sustainable growth rates. Labor productivity gains have likely peaked. Entering potential negative surprise territory. See TWO GREAT YEARS! WHAT NOW FOR EQUITIES?.
UNKNOWN UNKNOWNS: ________________________________________.