Orlando's Outlook: Rally caps and 3-for-4 in June spark equity rebound
Bottom Line: With baseball’s mid-summer classic coming up soon in Kansas City, we’re reminded of the old adage that if a hitter fails seven out of 10 times, he can still make the Hall of Fame. Earlier this month, in the immediate wake of the Labor Department’s horrific May jobs report—in which the economy produced only 69,000 nonfarm jobs—stunned investors responded by dumping stocks, which plunged by more than 3% over the next two days, while benchmark 10-year Treasuries plummeted to a record low yield that touched 1.44%. That extreme valuation response triggered a buy signal for us, and we laid out five upcoming and potentially market-moving catalysts that we felt could justify our equity overweight position: the June 17 Greek elections; the June 19-20 Federal Open Market Committee (FOMC) policy meeting; the U.S. Supreme Court’s decision on the Affordable Health Care Act; the June 28-29 European Union (EU) Summit; and the July 1 Iranian oil embargo by EU countries. The market, in our view, was pricing in failure on all fronts, but it was our fervent belief that investors were overly pessimistic. As it stands now, we are batting three for four thus far in June, and stocks have rallied by about 7% since our buy signal, which has helped to ameliorate some of May’s dreadful 10% decline. Even with the outcome uncertain on next week’s Iranian oil embargo, we believe the die has been cast for a summer rally that will help move stocks toward our year-end target of 1,450 on the S&P 500.
Valuations remain compelling
A stable-to-improving macro environment, combined with late spring’s concurrent 11% collapse in stock prices and the powerful flight-to-safety rally in bonds, has left investors with very attractive equity valuations. Even with the recent rally off the early June lows, stocks are now priced at about 13 times estimated consensus S&P earnings of $104 for 2012, some 78% below the 1.66% earnings yield on benchmark Treasuries. The last times that stock valuations were so completely out of whack with Treasury yields were March 6, 2009 and Oct. 4, 2011—precursors to substantial rallies. Investor sentiment is extraordinarily bearish, and given that stocks typically perform well during the summer months of presidential election year—and given that we’re on a mini hot streak at three-for-four—it would appear that the fundamental catalysts are in place to potentially reverse bearish sentiment and drive stocks back to fair value. Consider:
- Greek elections turn out the right way At the end of the day, Greek voters swallowed hard and sided with the conservative pro-austerity New Democracy Party in a revote after the inconclusive May 6 elections, which had seen an angry citizenry side with the smaller leftist, anti-austerity parties. It’s still not clear how this will all play out. The new conservative-led government headed by Prime Minister Antonis Samaras stumbled out of the gate, introducing yet more drama in a country where drama got its name. Samaras suffered a detached retina and was unable to attend this week’s summit; his designated finance minister resigned two days after being named because of illness; and a second Cabinet member quit on conflict-of-interest allegations. The good news is that the new finance minister, Yannis Stournaras, is a respected economist who has publicly criticized Greece for not carrying out broad structural reforms to cut costs. The bottom line: the election essentially kicked the can down the road—but this is an outcome that markets already tired of this sideshow can live with for now.
- Fed follows FOMC playbook Fed policymakers kept their federal funds target rate at an historic 0% to 0.25% and extended “Operation Twist’’— the purchase of longer-term Treasury securities with the proceeds from the sale of short-term securities — by an additional $267 billion through the end of this year. The initial $400 billion program, which aimed to tamp down long rates, was set to expire this month. But the Fed did not initiate Quantitative Easing 3 (as we had expected) because the economy’s simply not that weak, and because the Fed needs to keep some powder dry, in the event that a cataclysmic global development unexpectedly drags the U.S. economy back into recession. More importantly, by slightly downgrading its outlook on already below-trend economic growth and unemployment through 2014, the FOMC signaled it stands ready to do more quantitative easing if necessary without explicitly committing to such. Frankly, we think the economy would have to ratchet down more sharply from here before the Fed would entertain a new QE3-type of program in the midst of a presidential election year. But with inflationary pressures easing on the sharp pullback in energy prices, the Fed has some room to move if it chooses to do so. The bottom line: the Fed’s doves continue to outflank the hawks, indicating the markets can expect the Fed to continue its accommodative monetary policy for some time, which is a positive for equities.
- Shocking ObamaCare verdict We clearly whiffed on this one, as the Supreme Court surprised us on two fronts. First, it upheld the law on a 5-4 vote by finding the individual mandate constitutional as a tax, an argument that received little notice as most experts focused on the mandate’s constitutionality, which the court did find violated the Interstate Commerce Clause. Second, the deciding vote was cast by Chief Justice John Roberts—who joined with the court’s liberal wing—not Justice Anthony Kennedy. Since most of the law’s major provisions and costs don’t kick in until 2014, there’s still time to decipher the impact—if the law holds up. Republican candidate Mitt Romney has promised to overturn it the first day he’s in office if he wins, and Republican congressional leaders are moving to strike as much of it down as possible before then. Still, what the decision won’t do is give the markets the sort of animal-spirits kick that we envisioned, with ObamaCare’s overturning serving as a sort of high-water mark for government involvement in the private sector and signaling a renewed era of pro-business policies in support of deregulation, economic growth and the financial markets. The bottom line: the decision wasn’t disastrous—finding the mandate violated the Commerce Clause signaled the court will be diligent in preventing Congress and the White House from overstepping its authority—but it was hardly an economic or financial-market catalyst. It just marks another five months of uncertainty for investors, although it may serve as a rallying cry to invigorate the Republican base for November.
- Surprisingly good news from the EU summit To be sure, investor expectations were near zero, what with German Chancellor Angela Merkel saying that Germany will never agree to a solution that relies solely on Eurobonds and effective mutualization of member countries’ sovereign debts as long as she’s alive. So what happened overnight already has surprised, and it was arguably the single most important and controversial item on our list. EU leaders agreed to the creation of a pan-European banking regulator, which would then allow for possible direct bank recapitalizations—in other words, mutualization of sovereign debts. And it also agreed to the purchase of sovereign bonds to stabilize markets in member states, including immediate and direct bailout funds to Spanish and Italian banks. The unexpected moves clearly signaled an easing of Germany’s austerity-first stance going into the two-day summit in Brussels—the 20th since the debt crisis erupted in Greece in 2010—sparking a strong rally in the euro and in both European and U.S. markets this morning. The devil is in the details, of course, and EU leaders weren’t all that forthcoming. Moreover, individual countries would have to sign off on ceding central authority, a task that’s never easy in a continent where cultural divisions make our country’s divisiveness look tame by comparison. But at first glance, it does appear that the summit will deliver critical pieces to a long-term roadmap that could lead to greater fiscal and financial integration, helping to ease market fears even if the reality is it simply kicks the can further down the road. The bottom line: the growth-now forces appear to have trumped the austerity-first forces at present (as we had hoped for), and that’s positive for the markets.
- Iran oil embargo set for July 1 Crude oil (West Texas Intermediate) soared by about 45% from $77 per barrel last October to $111 in March, largely due to a geopolitical risk premium associated with investor uncertainty surrounding Iran’s nuclear ambitions. Over the past four months, however, crude oil has round-tripped, plunging by more than 30% back to $77 per barrel as of yesterday. Seeking to force Iran to halt potential development of nuclear weapons, the EU and the U.S. adopted tough new sanctions a year ago targeting Iran’s oil exports, and a key part of those sanctions kicks in over the weekend. That’s when an EU ban on insuring shipments of Iranian crude takes effect, and because Europe dominates the world's tanker insurance market, it’s forcing China, Japan and other importers of Iranian oil to look elsewhere for oil, cutting off a key source of income for Iran. According to Morgan Stanley, Iranian oil exports have already fallen by 23% this year. The goal is to pressure Iran to abandon its nuclear ambitions, clearing the way to lift the sanctions, reintroduce Iranian oil into the global markets and ease geopolitical tensions. Iran owns about 9% of the world’s proven oil reserves, according to OPEC, which is the fourth-highest among the world’s countries, and Iran was the third-largest exporter of crude oil in 2010. If this situation can be defused diplomatically and Iranian exports resume, then recent declines in oil prices could potentially accelerate, providing a global economic lift to consumers and energy-intensive manufacturers. The bottom line: stay tuned.