Extrapolation is a Dangerous Game

According to the Merriam-Webster Online Dictionary, to extrapolate is “to project, extend or expand (known data or experience) into an area not known or experienced so as to arrive at a usually conjectural knowledge of the unknown area.” In other words, extrapolating essentially assumes that the past and present situation will continue going forward. Investors must be on constant alert not to extrapolate present trends too far into the future, or they may get surprised when their backwardly constructed view of the future turns out to be wrong due to cyclical or structural change that occurs naturally in our world.

Before the first quarter reporting season began, analysts were extremely negative on their outlook for corporate earnings based on the fallout from the global recession and the subsequent drop-off in corporate profits in recent quarters. It turns out that analysts have been right in their assessment of poor absolute numbers, but those that bet against positive equity returns during earnings season have been wrong as the earnings surprises (the difference between actual and consensus estimates) have been positive and markets have continued their upward trajectory. The bears will see this rally as a temporary smokescreen built on a weak foundation that is bound to fail. On the other hand, the bulls may be correct in believing that some of the gloom and doom baked into future earnings is overstated. In hindsight, investors should have questioned the complacency built into earnings estimates back in mid-2007. In my opinion, right now they should be questioning whether current analyst forecasts are too pessimistic due to recent trends. Caveat permabears – those who get caught overly “extrapolating” might be prone to getting hoodwinked by the consensus view again!

S&P 500 1st Quarter Earnings (approximately 90% of the index has reported as of 5/11/09)

Approaching the 200-day Moving Average

The stock market has rallied an impressive 36% in the past two months, as measured from the intraday low of 666 on the S&P 500 on March 6 through yesterday’s (5/7) closing price of 907. The index is now just 5% below its 200-day moving average of 956.  The 200-day moving average, as its name implies, is simply the rolling average of the past 200 days of closing market prices.  It’s widely used in the investment community as an indication of the market’s intermediate term trend.  Due to the severity of the current bear market, the S&P 500 has been below its moving average for an entire year now, having last reached it in May 2008.  Even then it only briefly touched the average rolling over into a steep leg down.  The market hasn’t traded consistently above its 200-day moving average since before the market top on 10/9/07.

We believe that it will be a positive development if the market is able to rally, and stay, above its 200-day moving average.  It would be a fairly strong signal that investors really are beginning to anticipate an economic recovery later this year.  On the other hand, if the market cannot breach and hold its 200-day moving average, it would serve as a warning sign that investors remain leery of a recovery and thus are reluctant to remain in the market after the recent gains.  Either way, we’ll be watching the behavior of the market as its approaches this important threshold for possible clues as to what may lie ahead.

Junk Rally or Not?

The S&P 500 has rallied from the March lows and is now standing in positive territory for the year. But I wanted to take a look at how we arrived at this positive performance. In the chart below I have in the left column the 2009 return for the S&P 500, all 10 GICS sectors (using ETFs), and four other widely followed indexes. In the right column are the 2008 returns.

	12/31/08 - 5/4/09		Last Year - 2008
S&P 500	1.58%		-37.03%
10 GICS Sectors
Staples	-5.47%		-15.02%
Healthcare	-7%		-23.31%
Utilities	-6.20%		-28.93%
Financials	-5.32%		-54.97%
Discretionary	11.55%		-32.97%
Technology	16.10%		-41.51%
Materials	20.26%		-44.05%
Industrials	-2.03%		-38.74%
Energy	3.44%		-38.97%
Telecom	11.10%		-42.04%
Other Indexes
Russell 2000	3.11%		-34.15%
MSCI EAFE	-1.54%		-41.04%
Emerging Mkts	24.55%		-48.88%
US REITS	-4.89%		-39.88%

In red I have identified the five worse performers for 2008, and their subsequent return year to date in 2009. You will notice the five worse performers (with the exception of Financials) are now the best performers this year. The current market rally seems to be made from oversold conditions on the hardest hit areas. Bear market rally proponents agree with this point, and further point to tricky accounting that are producing better earnings in these areas as reasons to be skeptical. They are waiting for a pull back or re-test of the March lows.

But, these five areas also share two important characteristics: they are high beta sectors that are generally characterized as early cyclicals (except telecom). I am encouraged by this sign of distinct leadership by historically early market leaders. And so are the bulls.

Low Conviction Forecasts

There seems to be a misunderstanding about generating an investment forecast that presumes that active portfolio managers always have a reliable one in their back pocket. Nothing could be further from the truth. Sometimes the forecast is as simple as “I don’t have a strong opinion one way or the other.” Such a forecast actually happens more often than not, and shouldn’t be a cause for alarm for investors. After all, forecasting is all about assessing future probabilities, and sometimes the data simply doesn’t allow for making a high probability forecast.

I believe that now is one of those times. Those that believe that they “know” what the outcome of the current state of economic affairs will be are making a high conviction forecast based on an unprecedented set of economic circumstances. There is nothing new about a country debasing its currency, and there is similarly nothing new about trying to inflate assets in order to prevent a debt liquidation and deflation. But it is certainly new to do so in an economy as deep and diversified as the U.S. economy, and to do so in such a coordinated manner within the global economy. By our count we are now up to about $12 trillion of guarantees and promises to invest by the various agencies of the U.S. government, and that is in the context of a $14 trillion economy. Who can “know” where this will lead?

Low conviction forecasts are not a problem for us as a relative value manager. In this case we get more, rather than less, diversified. In addition, we manage portfolio risk to be closer to our client’s risk benchmarks, as opposed to making large bets one way or the other. Our assessment of whether or not this latest 30% rally off of the intraday low of 666 for the S&P 500 Index represents the beginning of the next cyclical bull is inconclusive. At the moment I would characterize the situation as a coin flip either way, and in that situation we will hug our benchmarks, more or less. However, there is no doubt that the entire investment team would be more comfortable if the market would back and fill a little, and give us the opportunity to add to risk positions after a meaningful retracement of recent gains.

Consumption Spending and the Second Derivative

My colleague, Carl Noble, recently wrote about the latest GDP numbers, and mentioned that we view them as mostly backward looking at Pinnacle.   Last Thursday, the March report on Personal Consumption Expenditures (PCE), which is just geek speak for consumer spending, was released.  Consumer spending data always grabs our attention since spending is such an important driver of GDP growth in the U.S. economy, and we believe it has shown to be a good leading indicator for equity markets when tracked on a rate of change basis.

The latest data point on the chart below shows a year-over-year decline in spending of -1.2% through March, which on the surface appears quite unconstructive for the economy and financial markets.  But on the bright side, there’s actually been three consecutive months of improvement since the low point of -1.5% in December.  The increase or decrease in the rate of change is commonly called the “second derivative,” and many analysts believe that the stock market is responding to the improvement in the rate of change across a variety of different indicators recently, even though most, like consumer spending, remain in decline. In other words, what we’re experiencing is a “second derivative rally.”

Breaking 3%

On March 18, 2009 the Federal Reserve announced plans to purchase $300 billion of long-term government bonds in an effort to lower rates on mortgages and other debt instruments. The ten year Treasury was trading at 3.01%, which seemed to mark the point of defense for the Fed. Yields on the ten year quickly fell to 2.5% after the big announcement (as marked by the red arrow in the chart below), and Fannie Mae mortgage commitment rates dropped to 4.25%.

But on Wednesday, following the Fed’s latest meeting, there was no announcement on future purchases – and the Treasury market did not like that news. Yields broke above the key 3% level and now stand at 3.12% and are rising. Are supply issues due to future funding of the fiscal deficit weighing on investors’ minds? Are deflationary forces subsiding, reinforced by a strong reading of the GDP Price Index? I feel there are many different contributing factors to this rise, but one thing seems certain – the Fed will have to really ramp up their efforts if they wish to keep interest rates from rising any higher.

First Quarter GDP – Very Bad, But Backward Looking

The first quarter GDP report was released yesterday, and it wasn’t very pretty.  Real GDP, which is the primary measure of overall economic activity, declined at a -6.1% annual pace in the first quarter, which was only minimally better than the -6.3% drop in the fourth quarter. Economists surveyed before the report was released estimated that the decline would be -4.7%, on average, so it was considerably worse than expected.  Within the report, private investment and trade were very weak, while personal consumption was surprisingly strong.  You have to look back to the early 1980s to find quarterly contractions in GDP of this magnitude.

Although GDP captures a lot of attention, from an investor’s standpoint, the important thing to keep in mind is that GDP is a backward-looking report.  By that I mean it reports economic activity that occurred 2-4 months ago (January – March).  While we certainly pay attention to GDP, we spend more time focusing on other data that might give an indication of what lies ahead, as opposed to what’s already happened.  Lately, a variety of indicators have given the impression that economy is attempting to stabilize, which is the first step in recovery.  We don’t expect the economy to begin growing again before the end of the year or possibly even next year, but it seems that the worst of the contraction may have passed.