Looking Back & Forward
The better it gets the better it gets – Another exceptionally strong month for risk assets with equities rising 8% and posting their 3rd best July month on record. The
rise in risk assets was supported by broad improvement in economic data – both domestically and globally – as well as a reporting season which has again provided
an indication as to how flexible (and aggressive), corporate America can be in addressing costs. 9 out of the 10 S&P 500 sectors have experienced earnings
upgrades post results, taking the consensus 2010 EPS estimate for the market up to $72.9 – above what we estimate is the long-term “trend” level of around $72.
If anything, performance through July can be characterized as consistent – equities outperformed bonds, and within equities, emerging markets outperformed
developed, small outperformed large, and value outperformed growth. In addition, cyclicals outperformed defensives, and commodities rallied strongly. The only
inconsistency that did emerge was the weakness in Crude (and Energy equities), which have tended to trade as growth proxies, and the US dollar, which despite
broad risk taking (risk measures all improved), held in better than in prior periods of re-risking. Volatility levels were down in line with the rally in risk assets, with the
VIX back to 26 (vs. peak at 81) – back in sight of the average level (19.1) that prevailed for the two years through 3Q08.
Surprisingly, despite a 46% rally from trough, sentiment indicators remain neutral (AAII Bull/Bear Ratio, Nasdaq speculative positions, Put-Call parity, and even the
Consensus Inc. Weekly % bullish stocks ratio – p 42 ), valuations are not particularly stretched with our COV model implying 22% of value is being driven by future
earnings versus the average of 26% (p 40), and cash levels are supportive of the market trading higher still. Already we have seen the S&P 500 trade at the very top
end of our 950-1000 range, and the potential for it to trade as high as our stretch target of 1100 (14x 2-year forward earnings) is rising in line with continued earnings
upgrades and positive data momentum.
Economy – Improvement in Data Continues this Month - US 2Q GDP came in better than market expectations at -1.0% annual rate, compared to a revised 6.4%
annual rate of decline in 1Q. Final domestic demand fell 1.5%, as consumer spending declined (-1.2%) after a minor rebound in Q1. Housing data surprised
positively this month indicating the worst might be behind us. Housing starts (rising 3.6 % m/m) and new home sales (up 11% m/m) came in well above expectations
in June, pending home sales rose for the fourth consecutive month, and existing home sales rose for the third consecutive month. The S&P Case-Shiller home price
index rose for the first time in almost three years. The index rose 0.5% m/m in May, the first gain since July 06 and the biggest since May 06. The ISM Manufacturing
index rose for a sixth consecutive month to 44.8 from 42.8 in June. However, not all the economic news was good. Consumer confidence as measured by the
Conference Board slipped for the second consecutive month in July to 46.6 and the U Michigan Consumer Sentiment index fell after surging for four consecutive
months. Durable goods orders fell more sharply than expected in June (down 2.5%). Ex-transportation equipment, new orders unexpectedly rose 1.1%, the most in
four months. Better than expected, Industrial Production fell 0.5 % m/m in June, while capacity utilization fell at a slower pace to 68% in June. See page 7 for an indepth
look at July economic data.
Earnings – The 2Q09 earnings season is 79% complete by market capitalization (352 out of 500 companies). Of these, 72% of companies have reported at/above
expectations, although after a strong start by the industry leaders (JPM, GS, C, BAC), Financials have come in the most below expectations on a $ weighted basis.
The extremely high ratio of earnings beats provides some indication of how low expectations were in the lead up to the reporting round. On a blended basis (reported
+ unreported) earnings are down 18.8% YoY (-26.4% ex-financials). On a $ basis, cyclicals beat expectations by 17% and defensives by 2%. Revenues have met
expectations, but operating margins continue to surprise (100 bps for EBIT) as cost control remains exceptional. Revisions have steadily risen through this period,
with 9 out of 10 sectors recording a positive change in NTM earnings. Earnings beats have also been backed by rising estimates from those sectors the with largest
beats; Materials and Discretionary have seen the largest positive change in consensus estimates to 2009 earnings. A worrying sign, though, is that earnings spread
(coefficient of variation) remains highly elevated, while consensus estimates already have 4/10 sectors set to post record profits in 2010 with ex fin ROE returning to
its 2008 peak.