Fly me to the moon
Let me play among the stars
Let me see what spring is like
On a-Jupiter and Mars
In other words, hold my hand
In the last Miller’s Market Musings written 2 weeks ago, I closed with the following:
Markets have bounced very nicely in the past week and a half. Will it continue? I think the S&P 500 could easily move up to 1950 or even 2000. After that, I expect it to bounce between 1850 and 1930 for a while, i.e., until China comes apart. Then it will be time to play defense and wait for the next down leg to occur. But in the meantime, I’m going to repeat what I said at the end of the last letter: what’s really interesting is what is happening beneath the surface. I think a wave of M&A is coming to community banks, and that companies that have been crushed on the back of oil’s decline and aren’t actual oil drillers are, for the most part, interesting investments down here. Leadership in the markets will shift from growth to value and large-cap to small.
Blatant self-congratulations alert: that’s basically what happened. The SPX closed at 1999.99 (I’ll call that 2000) on Friday, while in the past two weeks the SPX is up 4.3%, the small-cap Russell 2000 is up 7%, and the KRE (regional bank ETF) is up 9.2%. This game is easy.
So what drove this big move? I think it was a combination of oil prices going up lessening the need for Sovereign Wealth Funds to sell stocks to meet funding needs, selling pressure easing by macro funds, Chinese economic officials making noise about not devaluing the Yuan “for competitive reasons,” and high-yield bond spreads tightening (although they are still fairly wide). There are a number of other, less important factors, but I think those are the main ones.
So where do we go from here? I think the overall market will probably churn around 2000 for a little while, but the sub-sectors will have fairly divergent performance. Banks probably have another 3-5% upside, while high-quality energy stocks could also continue to move higher. The sectors that have been the “safe” havens for stock investors will probably become less safe. Consumer Staples companies like Campbells Soup (CPB), Clorox (CLX) and Kelloggs (K) are trading for incredibly high valuation multiples, mainly because they were being used as a hiding place. Similarly, investors that have been searching for yield anywhere it can be found have driven yields on Utilities to about 3.5% overall, which, to me, is a too low to make a safe investment, especially given the massive changes occurring in how we generate and distribute energy. With the XLU utility ETF trading right at its highs for the past year, I’d be a seller of safety and a buyer of the beaten down sectors.
What’s keeping me from being more bullish? A number of things. In no particular order:
We’ve had a big move from very oversold levels. The fear trade has worked. From here, there will be a bit more covering and performance chasing, especially in sectors where credit issues were feared to be fatal, but the easy money has been made.
China is still a mess. The powers that be are going to be setting some 5 year plans this weekend, so there may be some soothing headlines coming out soon, but overall, their growth is slowing, their debt is growing, and the combination will eventually end badly for them. Now, given that it’s a closed economy and the government can just print Yuan to recap its banks, I don’t expect to see bank failures like you would see here – they will just infuse equity where it’s needed. Some will argue that all this money printing will cause the Yuan to depreciate, but since the Yuan doesn’t really free float, this isn’t guaranteed. Besides, all the other major economies except the U.S. are also printing massively, so on a relative basis to the Euro or Yen they aren’t doing anything that different. That said, the crackdown on dissent, and fear of a more oppressive regime to come, has driven up capital flight, and I only expect that to continue. Eventually, they will have to either let the Yuan depreciate or institute stronger capital controls. When will this happen? Probably further in the future than the China bears think possible, but a lot depends on how fearful the rich in China become about their ability to get money out at all.
Europe is still a mess. Draghi thinks that the Euro economies are so bad that he keeps pledging to “do whatever it takes” to stem the decline every time he speaks. He’s giving a big speech this week, so we’ll get to hear more about his easing plans, but at the end of the day, massive QE isn’t working, hasn’t worked, and won’t work. So Europe will continue to muddle along with economic growth right around zero.
Japan is still a mess. While we’re speaking of massive QE that hasn’t worked, Japan is still unable to produce any real economic growth despite 20 years of near zero rates and now, negative rates. I’m always amazed at the stupidity of the central bankers who think that they can “create” demand by raising and lowering rates that no one borrows at anyway. As I’ve said in prior posts, if you want to get lending up and spending up, let rates be higher. Savers will have more money to spend and banks will be incented to lend because they will actually get paid to do it. With rates where they are, savers are being crushed since they have no current income, and banks aren’t willing to lend long-term at really low rates because frankly, it doesn’t make any sense to do so. But in the la-la land of central bankers, their models all show that lower rates mean more economic growth. The fact that the evidence from economies around the world shows just the opposite seems to not matter.
The U.S. stock market, as represented by the S&P 500, isn’t really cheap. Consensus estimates range from 115 to 125 in earnings for it for this year, so it’s trading at around 16-17 times earnings. Not crazy expensive, but not super-cheap. So we muddle along.
Fill my heart with song
And let me sing for ever more
You are all I long for
All I worship and adore
In other words, please be true
In other words, I love you
I do think some individual stocks look really attractive, and we are long a number of solid community banks as well as some of the largest banks, which look very cheap here. Bill Gross put out his monthly letter on March 2nd and said to get out of the banks, but I think he’s wrong. Mike Mayo, who was bearish on the big U.S. banks for 20 years, is out pounding the table to buy the big 4 at these levels, and I agree with him (full disclosure: I used to share a cab to work with Mike most days about 20 years ago, and I think he’s a good guy). We’re also long some energy stocks, a few solid healthcare companies, and a few retailers trading at 4-5x EV/EBITDA with no debt.
Some have recently been knocking the long-term prospects for banks, saying that they are never going to trade at a decent multiple of book or earnings, because they will be unable to earn a decent ROE. This argument usually says that the banks are now like utilities, over-regulated, over-capitalized, and unable to generate much above a 10% or so ROE. My thought is that if banks are like utilities, that’s not necessarily a bad thing. The average utility in the U.S. is yielding just 3.5% with very high payout ratios and sky-high P/E ratios. Once upon a time, banks actually were traded like utilities (this was back in the 1950s and 1960s), where their dividend yields were what mattered. Over time, the metric shifted to P/E ratios and earnings growth. But if we go back to the way things were, and banks are viewed as a stable source of dividend income again, I’d argue that their valuations would go up about 50%. I’ll take that.
This week’s Trading Rules:
Markets have ripped as the fear and panic that gripped markets in mid-February diminishes. I think this rally is about done. We probably just muddle along here around 2000 as market leadership continues to shift, but I think S&P 500 could fall back to 1950 fairly easily. If it breaks 1940, I’d expect it to retest the recent support around 1850, then to bounce between 1850 and 1930 until some exogenous, macro situation causes another round of selling. Then it will be time to play defense again.
SPY Trading Levels:
Support: 195, 191/192, then 183/185.
Resistance: 200, 204.5/205, then a lot at 209/210.
Positions: Long and short U.S. stocks and options. Short stock or long puts on CPB, CLX and K.
Miller’s Market Musings is a free bi-weekly market commentary written by Jeffrey Miller, who has been managing money through various market environments for over 20 years. You can subscribe here.