The Disturbing Expectations-Reality Gap Between Stock Prices and the Economy

The Growing Gap Between Economic Reality and Equity Investors
As an economic indicator, the PMI (purchasing manager's index) is a very important sentiment reading for both the manufacturing and service sectors, with the reading of 50 being the make-or-break line between and expanding or contracting economic activity. As with many other indicators, the rate of change from month to month is also important, and PMI is considered a leading indicator in the eyes of the Fed and other central bankers. However, a comparison of JP Morgan's global PMI, central bank policy initiatives and the stock market as represented by the S&P 500 shows a disturbing trend. In other words, there is a growing divergence between investor expectations as reflected in stock prices and the real economy as reflected in the JP Morgan global PMI. 

The post 2008 financial crisis peak in global services and manufacturing PMI was actually way back in early 2010. As central banks began to wind down the extraordinary liquidity the Fed and other central banks pumped into the global financial system to prevent a meltdown in 2008/2009, the global economy began to sputter. With central bank extraordinary liquidity waning and the global economic recovery obviously losing steam, the S&P 500 hit a post 2008 crisis peak of 1,217.3 in April 2010.

As the Fed responded with QE2 after the ECB introduced a securities market program, Greece was bailed out and the BOJ began fund provisioning for Japanese companies, the global PMI rebounded, and stock prices rebounded in anticipation of a renewed recovery in the global economy. 

However, the impact on stock prices and global PMI from the additional shot of monetary stimulus from QE2 proved much more transitory than the bounce from QE1, as global PMI hit a rebound peak well below the early 2010 peak in 2011 and again headed for the "50" boom/bust line. As the global PMI continued to deteriorate on increasingly serious Eurozone contagion, the Fed was forced to come up with Operation Twist in an attempt to push bond yields at the longer end of the curve downward without further expanding an already swollen balance sheet. The ECB's belated LTRO (long-term refinancing operation) to alleviate growing dysfunction in the Eurozone money markets because of core bank balance sheet concerns most likely had an even more favorable impact on investor sentiment than the Fed's Operation Twist. The Fed's and ECB's monetary actions were complimented by action from the ever-cautious BOJ, to further expand its asset purchase program and more actively utilize its balance sheet. 

The general impression (and relief) given to investors was that developed nations' central banks were resolute and fully committed to preventing not only a repeat of the financial crisis, but also to supporting a sputtering recovery. In response, investors pushed the S&P 500 to a new rebound high of 1,408.5 in March 2012. However, the favorable impact on the global economic recovery from these actions was miniscule, and even more transitory than QE2. Global PMI temporarily upticked, but soon renewed its plunge back to and below the "50" expansion/contraction line. What this means of course is that stock prices are now supported almost entirely by the hope that further monetary action will revive the global economic recovery, whereas the reality of the PMI and other economic data is that the condition of the global economy continues to deteriorate instead of improve, in no small part due to the negative Catch 22 nature of the Eurozone crisis. 

Source: StreetTalk Advisors

The above chart from Street Talk advisors shows the high similarity between the latest "Eurozone may be saved" hope and the previous ray of hope as in“Blue-chip stocks posted the biggest gain in more than two months as signs of progress in Greece’s debt crisis sparked a broad market rally” – (WSJ, June 28, 2011). In other words, hopeful investors are again being set up for a renewed fall in stock prices, with even less underlying support from the real economy than a year previously. For the last two years, the EU has enacted one emergency bailout after another, only to have to come back and try again in increasingly shorter time periods, because they still have have found a way to backstop bank balance sheet risk and/or paint a credible picture of just how the weaker Eurozone nations can work their way out of a Euro straight-jacketed debt spiral without breaking up the monetary union. 

A Widening Negative Spiral Whose Roots are in the Eurozone 

The worsening Eurozone crisis is causing depressionary conditions in Greece, Spain, Portugal and the Club Med Eurozone countries, and is even dragging down German growth, as front-loaded austerity measures exacerbate budget deficits, reduce tax revenues and worsen the economic funk. Dragged down by weak demand from the Eurozone, China's major export market, and a bursting domestic property bubble, the Chinese economy is slowing by more than the official numbers show. The slowdown in China in turn is a growing drag on Japan's economy, as China is now Japan's largest trading partner. Slowing demand from China is also a major drag on key commodities, which in turn is dragging down economic activity in Brazil, Australia and the major commodity nations. Weak European demand is also a noticeable drag on U.S. In addition to being perennially a day late and a dollar short with countermeasures, George Soros observes that the Euro authorities don't understand the real nature of the Euro crisis, the result being that the key issues have not been addressed and the situation continues to deteriorate.

The U.S. as the Last Man Standing is Looking Shaky
 The ECRI and Lakshman Achuthan are really digging their heels in on their recession call, which even they have to admit was quite early (last September) even though they now say their initial recession call was Q1, Q2 2012, and they now believe the U.S. is already in recession, even though the Conference Board says the risk of a downturn in the U.S. economy in the second half of 2012 is relatively low. The U.S. Fed has, 1) reduced forecasts for growth in 2012, 2013 and 2014, 2) has a more dim view of unemployment and 3) has reduced inflation expectations (which were already below the 2% target). The Fed has also noted that the recent economic crisis left the median American family in 2010 with no more wealth than in the early 1990s, erasing almost two decades of accumulated prosperity.

Hat-Tip:: Econompic

Why Dumping/Shorting Bonds is Still Not a Good Idea

While many analysts point to all-time lows in U.S. treasury yields as evidence that the next great bubble to burst is in U.S. treasuries, the deeply engrained Eurozone problems and the heavy overhang of debt throughout the developed nations, as well as our experience with ever-falling JGB yields throughout Japan's Heisei Malaise through the 2008 financial crisis strongly implies that dumping/shorting treasuries and piling into equities is still not a good idea, because inflation and growth are still very elusive. As hopes for renewed growth have again faded, US treasuries have again been outperforming the still positive YTD equity gains (8.3% for the SP500, 12.7% for the Nasdaq and 5.4% for DJIA in the first half) by a wide margin since late February, as the big picture remains deflation, not inflation.

Hat-Tip: Econompic

Japan's Domestic Reconstruction Only a Temporary Respite

On the surface, Japan's economy is looking relatively more bouyant, supported by long-delayed reconstruction after 3.11.2011 earthquake/tsunami/nuclear disaster in the Tohoku region. The bounce-back from the deep post-2008 crisis was severely hampered by the Tohoku disaster, and there are signs that Japan's economy remains structurally weaker than before the crisis, with lingering summer power shortage issues and the additional burden on consumption from the looming imposition of significantly higher consumption taxes. On an annualized basis, Japan's GDP in annualized terms jumped 4.1% in Q1 2012 or better-than-expected and has risen annually for three straight quarters, led by demand for rebuilding the earthquake-hit northeast and revived subsidies for buying low-emission vehicles. 

Source: U.S. Federal Reserve

 But the government has long since shot its last fiscal bullet to support the economy, and seems intent on adopting austerity-focused policies (higher taxes) in response from international agencies like the IMF and warnings from its own Ministry of Finance that Japan is reaching the limits of its ability to self-fund what is already a massive and still growing government debt burden. While the BOJ pleasantly surprised investors with further expansion of its asset purchasing program and an inflation target in February, it continues to underwhelm investor expectations. Thus judging from the BOJ Tankan and leading indicators such as machinery orders, the first two quarters of 2012 may be the peak in the reconstruction-led recovery, while the export environment continues to deteriorate--leaving the benchmark Nikkei 225 to struggle at levels still below its 200-day moving average, i.e., Japan stock prices are still basically in a downtrend following the the Q1 rally that essentially discounted the reconstruction-supported GDP bounce.

Japan's politicians are hopelessly gridlocked with the ruling DPJ (democratic party of Japan) itself on the verge of breaking up over economic policy differences, and no one seems to have a clear idea of how to rebuild and revitalize the economy, leaving austerity, not structural reform, as the default policy.

Japan Equity Long-Short Hedge Funds Should be Thriving
Basically, buy-and-hold died a long, long time ago in Japan, and the best way to look at Japan now is as a big warrant on the global economic cycle, particularly investor perceptions of that cycle--i.e., pick up some Japanese stocks at the peak of "risk off" phases, while selling any temporary surges of hope over reality. If your timing is off, stock prices trading at or below book value and the continued strong yen will limit the downside, but do not expect any significantly favorable re-appraisal of Japan's growth prospects in your lifetime.

Looking at the YTD performance of the Nikkei 225 constituents shows a dramatic polarization among individual stocks, within sectors and among sectors. If your exposure to the automobile sector, for example, was in Subaru manufacturer Fuji Heavy (7270), truck-maker Hino (7205), tire maker Yokohama Rubber (5101) and automobile component producer Denso (6902), you couldn't help smiling at the nice 30%~20% YTD gains. If on the other hand you mad the mistake of owning Mazda (7261) or battery maker GS Yuasa (6574), your holdings in the sector would be down, not up, by a similar amount.

The only sector-wide theme visible in the best and worst 20 stocks in the Nikkei 225 was real estate, with Sumitomo Realty (8830), Mitsui Fudosan (8801) and Tokyu Real Estate (8815) offering 30%+ gains.

Avoid Large Cap Japan Stocks Like the Plauge
While long the first choice among large domestic pension funds as well as top-down foreign investors including sovereign wealth funds and big pension funds, Japan's large-cap stocks are the last place to look for both a) alpha and b) capital preservation, dividend yield. As can be seen by the following graph of performance by market-cap size, the Topix 30 Core index of large caps has been the major drag on top-down performance of Japanese equities, despite the all-too-brief Q1 bounce. 

Source: Nikkei Astra

Indeed, we believe foreign investors should continue to reduce positions in core large-cap Japanese equities on any rallies, because that is exactly what Japan's large institutional holders are doing as domestic pension funds abandon their "home bias" allocations to domestic equities, and domestic corporations unwind their strategic holdings in other companies.

Indeed, the best hope for decent alpha is in the smaller cap and "new economy" JASDAQ, which continues to hold its ground despite the heavy selling of large cap stocks. Domestic investors are abandoning their top-down closet Topix-based indexed portfolios for much more focused "stock picker" portfolios of 30 to 50 names, while the new economy stocks like Softbank (9984) and Rakuten (4755) continue to do quite well, as are foreign investors with portfolios of selected small and mid-cap (by Japanese standards) stocks. By the same token, hedge funds who have typically gone short big caps while being long small caps should also be doing well.