Show me the Money!

Jerry Maguire was the 1996 American film starring Tom Cruise which remains popular today largely due to its memorable quotes. In the film, Cruise plays Maguire, a sports agent who is attempting, with limited success, to secure a major contract for his American Football playing client, Rod Tidwell (Cuba Gooding, Jr.) During a telephone update on his contract negotiations the exchange gets somewhat heated and culminates in a frustrated Tidwell shouting repeatedly at Maguire “Show me the Money!”

After three months of an extraordinary turnaround in equity markets, investors are now yelling “Show me the Green Shoots” at the market in a similar style to Tidwell. Although, it now seems pretty unlikely that the world economy will experience a recession of the magnitude of the Great Depression, the recent rallies in credit, equity and commodity markets have stalled signalling that buyers are currently exhausted and maybe not quite so optimistic about the future. The concept of “less bad” can only carry markets so far. The strong gains in the second quarter of this year have served to return valuations closer to fair value from the worse case scenario. From here on in, it would seem that the markets are now demanding firm fundamental evidence of the economic recovery.

So does this current stall represent a pause or a sign that markets will turn back and we will see the next leg down in this bear market? In terms of valuation, equity prices and credit spreads are now at levels usually associated with a recession rather than a slump or a depression. In terms of the fundamentals there are signs of improvement in the global economy, most notably in China, the rest of Emerging Asia and the resource markets. Elsewhere, economic recovery is definitely more subdued and perhaps rather suspect supported by the helping hand of governments. The mass of liquidity created by both monetary and fiscal stimulus has been the key to avoiding a depression up until now; however, this has all come at a cost. It will be critical to the recovery that governments continue with a loose money policy for as long as required but then tighten again before inflationary pressures reassert. This formidable task, in the opinion of bond markets, is asking too much of government officials and government bond yields have consequently been rising in recent weeks.

For now it appears appropriate to be cautiously optimistic about the economic recovery. As we have often said statistical and economic data releases have a tendency to be backward looking, generally because of the time needed to collate, verify and then release data. For a more forward looking view, surveys are often used, although sentiment indicators should usually be interpreted as a contrarian view. For example, survey data about new orders in the US is currently showing an up turn which in the past has tended to correlate to a positive change in employment figures. This is a positive sign after last year’s collapse in demand, which saw companies quickly de-stock and shed labour. New orders should translate into increases in industrial production, further employment, rises in both corporate and personal income as well as a recovery in consumer demand. Of course, there is the danger always remains that the consumer will prefer to save rather than spend.

We believe that these markets will continue to be driven by fear as investors weigh up the fear of being in the market versus the fear of being out of it. It would not be a surprise to see the markets move sideways whilst investors continue to grapple with their emotions. On my desk I have, in recent weeks, collated economic research which can evenly be distributed between the bull and bear case. The arguments put down by both sides are fairly well balanced. This crisis was caused by the scarcity of credit and this is gradually improving day by day through effective government policy. As we have already said a number of surveys are showing signs that the fundamental data is improving. However, this is countered by concerns that economic growth will disappoint next year and markets are now trading at or near fair value.

The strategy in a market that moves sideways is not as clear as the one adopted in a trending up market. The cyclical driven equity rally has created opportunities for managers to carry out a tactical summer rotation in their portfolios. The rise back to more realistic valuations has been achieved and we believe the key to future returns will be relative value so stock selection will be vital. Small and mid cap stocks have outperformed their large cap counterparts, to switch now to large caps may provide the best relative returns in these volatile markets. We will now use periods of weakness to build our equity exposure once again. We favour the growth markets of Emerging Asia and resources for the long term. Finally, there are no early signs of inflation as unemployment continues to rise coupled with the recent declining commodity prices. Therefore, printing money will continue to support the corporate bond market for the present. Whilst, we have seen vast amounts of money flow into this asset class and effective de-leveraging in the sector, we remain bullish on this asset class.

John Husselbee
14th July 2009