Tuesday, June 8, 2010

Macro Picture Mixed and Muddled, Straddling the Line in the Sand

As I wrote in a recent entry, the bulk of our mental energy is concentrated on puzzling through whether or not fear is driving this market, or whether we are being given signals that fundamental change is occurring. Recently, we have been scouring important data points and reassessing the very core of our thesis. I’ll focus on the macro-economic front today.

There’s clearly been some deterioration in the economic backdrop, most notably in measures of stimulus that factor in currency exchange rates (a quick appreciation in the dollar takes away stimulus in the U.S. by making exports more expensive), as well as some real-time indicators of global growth (copper and other commodity prices have fallen). The recent move higher in certain inter-bank credit measures has also added to the deterioration on the macro side, although they’re still well below levels reached in the credit crises of 2008. Despite these developments, many measures of growth and manufacturing still look strong, earnings appear to be healthy, and overall credit conditions have improved considerably.

How about the all-important jobs picture? Prior to Friday, the jobs trend was improving, but Friday’s poor employment report (excluding census workers) was a big disappointment. It’s important to note that the trend of hiring is more important than any one report, and the trend had been getting better prior to Friday. We believe that employment holds the key to this cycle possibly extending further. If Friday represents a new declining trend, that is certainly not good news. But we aren’t ready to draw that conclusion yet, so stay tuned.

All in all it, the data seems to be implying that there will be a moderation in growth going forward. How much moderation may hold the key. A typical mid-cycle correction may be occurring, and a re-rating for a slower rate of growth does not necessarily mean a recession is in the cards.

European risks represent the wild card in the equation. Unfortunately it is very hard to accurately determine to what degree growth will be affected due to the strains coming from Europe. The effects of a stronger dollar in the U.S. may be offset by stronger exports coming from the larger countries in the Euro-zone. As long as a cancerous debt contagion doesn’t spread, the developments in the Euro-zone may act to keep the Fed on hold for longer, ease China’s concern of overheating, and promote a united Euro-zone effort to support fragile markets. So-called “auto stabilizers” such as oil prices and yield levels have dropped and that should act to stabilize growth going forward. But this positive view must be balanced against growing system risk mixed with a divergence in opinion of how best to combat the current problems. The European view of austerity is currently facing off against the American view that Europe needs to protect growth first and worry about debt later. Opposition in views at the G-20 meeting this past weekend do not give me the feeling that we have a unified fight on our hands, and that’s a worrisome aspect to the current situation.

In short, the macro picture is mixed and muddled – there has been some deterioration in some fundamentals, others are holding strong, and an important wild card in Europe.

Given an increasingly confusing macro picture, and some deterioration in technicals, we have drawn a line in the sand at 1,040 on the S&P 500. Sentiment and fear levels, mixed with an important support point, argue that we should be bouncing now if this is just a deep correction in the ongoing bull market. However, if the bears find a way to break the 1,040 level, than we will acknowledge that something in our thesis may be broken. With risks rising and a broken view, we will remove some volatility from portfolios as a matter of prudent risk management. We hope 1,040 holds, but we’re prepared to adjust our allocations if it does not.