Prepared by Jeffrey Saut
Raymond James Financial, Inc.
"And A Partridge In A 'Pair' Tree"
(September 13, 2010) I recalled the lyrics "and a partridge in a pear tree" when an institutional account asked me for some "pair trade" ideas. Recall that "pair trading" is considered a market neutral strategy whereby you match a long position in one stock while selling short an equal dollar amount of another stock that is strongly correlated with the long stock position. Then, if the correlation weakens, hopefully your long position rises while your short position falls. For example, from our research universe a pair trade might consist of buying Regal Cinemas (RGC/$12.25/Strong Buy) and selling short an equal dollar amount of Speedway Motorsports (TRK/$14.97/Underperform). For guidance, I called one of the smartest pair traders I know. His response was, "Don't do it!" "Why?" I asked. "Because correlations are as high as they have been since 1987," he replied. Further research reveals that he's right, for arguably the best pair trading hedge fund in the business is down 11% year to date. Here's why.
Chart 1 shows the correlation of S&P 500 stocks to the S&P 500 Index. Studying the chart one finds that the correlation from September 2009 through early May 2010 ranged between 55-65. However, following the May 6 "flash crash" the correlation leaps to -78 and eventually -82, which is indeed the highest correlation since the 1987 crash. So what caused this fairly rare event? In my opinion it is because the retail investor--disgusted with high-frequency trading, dark pools, trading huddles, inter-market sweep orders, etc.--simply left the game, leaving the "pros" to trade among themselves. Obviously, when the alleged "dumb money" left the party correlation had to rise. Adding to the situation has been Exchange-Traded Funds (ETFs). To wit, when volume increases in say the Powershares Consumer Discretionary ETF (PEZ/$21.08), that ETF automatically goes in and buys ALL 60 of the mid-cap stocks within the fund. Plainly, that causes correlation to rise.
The conclusion from my brief study is that pair trades are not working. Consequently, to make money you must take only one side of a position, either long or short. A potential insight is that as correlation recedes it might imply retail investors are returning to the equity markets. Currently, however, this is not the case, for as repeatedly stated, "I have not seen retail investors so unwilling to discuss stocks since the fourth quarter of 1974." That gleaning is reflected by the sentiment figures and the money flows out of equity mutual funds. With such a dour mindset, I think "Something's Gotta Give." That belief is driven by the fact that corporate profits continue to explode. Indeed, with 99% of the S&P 500 (SPX/1109.55) companies reporting, operating earnings for 2Q10 have increased roughly 52% year-over-year to $21. Ladies and gentlemen, the peak in quarterly earnings tagged $24.06 a few years ago. Hence, we are roughly $3 away from bettering all-time peak earnings! Currently, this year's earnings estimates for the SPX are hovering around $83, while next year's are sticky around $95. The question then becomes, "What price-to-earnings multiple will Mr. Market put on said earnings if those estimates prove accurate?"
Alas, that is always a difficult question because the stock market is truly "fear, hope and greed only loosely connected to the business cycle." Some negative nabobs suggest that the P/E multiple should be in the single digits. Other, more optimistic types argue that with interest rates and inflation exceptionally low the P/E multiple should be 20x. The right answer probably lies somewhere in the middle. Using a median P/E multiple of 15x yields a price objective of 1425 for the SPX based on a $95 estimate. Using a 12x P/E multiple renders an 1140 price target. Yet one inquisitive portfolio manager asked me, "Jeff, how do you arrive at that $95 number?" I responded that I don't engage in such exercises, preferring to try and get things directionally correct. I then proceeded to relate to him what one of Wall Street's best and brightest stated on a recent conference call. The speaker was Dr. David Kelley, strategist for J.P Morgan Funds, and he had this to say (as paraphrased by me):
I arrive at my $95 earnings estimate for the S&P 500 in 2011 by assuming interest rates stay below 4%, nominal GDP grows at 5.8%, a 2% hop in productivity, and with unit labor costs falling by -0.3%. Considering that unit labor costs have fallen by -2.1% for the second year in a row, this is not an unreasonable assumption. If correct, at least in real terms, the value of output per laborer is increasing faster than workers' wages. Inasmuch, the gains in productivity are accruing to corporations. Add in low depreciation expense and the result is a profits explosion.
Obviously, that forecast foots with my belief that we remain in a "profits recovery" whereby profits soar, leading to an inventory rebuild that drives a capital expenditure cycle. Then, and only then, companies begin hiring, which fosters a pickup in consumption. Ergo, with surging profits bringing the SPX's earning's yield to 8.5% ($95 1110), I keep chanting, "I think it is a mistake to get too bearish here.ö Verily, if we were on the verge of a big decline it seems rather odd that many of the world's stock markets are strengthening with some of them actually trading to new recovery highs. If past is prelude, such action suggests the weaker markets should soon follow. And, that's what our stock market has done over the last two weeks, causing the SPX to break above its recent reaction high of 1105. My sense is we'll see more near-term upside with the SPX then stalling around 1115-1120, attempting to pull back without much traction, and then re-rallying. Eventually, I think we will break out above the August recovery high (1130).
If correct, my preferred strategy is to buy Putnam's Diversified Income Fund (PDINX/$8.07) and buy an equal dollar amount of some equity income fund populated with blue chip, dividend-paying stocks. Raymond James Asset Management Services has numerous Separately Managed Accounts (SMA), as well as a Unified Managed Account (UMA), that accomplish this. However, if you want to stay within the Putnam family of funds you might consider Putnam's Equity Income Fund (PEYAX/$13.43). While it may not yield as much as others, Bart Geer has been the portfolio manager for over a decade and for the past three-, five-, and 10-year periods has handily beaten his benchmark (Russell 1000 Value Index). It's worth noting that such a 50/50 asset allocation (fixed income/stocks) has never produced a five-year negative return in the last 60 years. Additionally, in an attempt to add alpha to the aforementioned portfolio, I like the strategy of layering in some individual stocks. Since the equity income fund covers the blue chip sectors, I would use prudently selected special situations.
Because I continue to favor technology, in past missives I have mentioned numerous tech names. To be sure, technology stocks are cheap, trading at their lowest levels relative to the SPX in almost two decades (1.0x the S&P 500). This has happened despite cashed-up balance sheets and good returns on invested capital. Moreover, there could be a paradigm shift afoot. Take Intel's (INTC/$17.97/Outperform) recent agreement to buy Infineon's Wireless Solutions Business (WLS), a leading provider of cellular platforms. Obviously, with the smartphone markets growing five times faster than the PC market Intel is hedging its "bets." Two names from our universe benefitting from this smartphone surge are American Tower (AMT/$49.07/Strong Buy) and Crown Castle (CCI/$42.40/Strong Buy). Or, consider the recent bidding war for cloud computing company 3Par (PAR/$32.92). Cloud computing threatens to shake the hardware and software businesses to their very roots. While there are many stocks in our universe that play to cloud computing, this morning I offer CA Technologies (CA/$19.78/Strong Buy) for your consideration (see our analyst's update).
The call for this week: I think we've gone from double-dip to double-drip as while the economy is slowing, a slide back into recession is unlikely. I also think the deflation theme has been deflated. Meanwhile, last week the Labor Day Indicator sounded the "all clear" signal when the SPX closed higher over the four days following the holiday. That rally took the SPX above its recent reaction high of 1105 and left it in position to challenge its 200-day moving average (DMA) at 1115. My sense is it will stall around that level and try to sell down. However, I don't think the selling will gain much traction, leading to a re-rally that will eventually allow the SPX to break out above its early August highs of 1130. Thus, unless the SPX violates its 50-DMA of 1085, followed by a break of 1060, I think the path of least resistance for stocks remains up. Still, investors continue to shun stocks, which has left the Equity Risk Premium (ERP) exceptionally large, as can be seen in the attendant chart. Indeed, "Something's Gotta Give!"
"Long-term duration asset prices are supposed to tell us something about long-term expectations. Recently, long-term government interest rates have reached new historical lows, and equity earnings yields have remained close to the very high end of their historical range. As a result, the equity risk premium (ERP), at nearly 10% has retested its extremely high level of early 2009. We thus face a striking paradox: investors prefer lending money to heavily indebted governments rather than to the prosperous, resilient and well-managed listed corporate sector. But the corporate sector is on a prosperous streak, with a constrained cost base and decent margins, and thus producing good earnings yields. Is this because equity markets are perceived as more dangerous than ever because of their super low risk/reward profile of the last decade?"
The Breakdown Of The Equity Risk Premium
September 13, 2010
Jeffrey Saut, Director of Research
Raymond James Financial, Inc.
880 Carillon Parkway, St. Petersburg, Florida
P.O. Box 520526
Independence, MO 64052-0526