Valuation & Risk On/Off

There must be a huge Risk On/Off track switch out there. Whenever it is flipped on, the S&P 500’s P/E moves higher along with commodity prices and most foreign currencies. When it is in the off position, money stops steaming down the fast track. Instead, it gets diverted into safe assets like the government bonds of the US, Germany, and Sweden. It also tends to jump off commodity currencies and hitch a ride on the US dollar.

The big switch was flipped to the off position following the May 6 French and Greek elections, which could upend all the bailout deal and fiscal pacts worked out by European leaders over the past two years. Such an outcome could push Europe deeper into a recession and weaken global economic activity. In other words, Risk On tends to be associated with widespread confidence in the outlook for global economic growth, while Risk Off indicates widespread fears that the global economy will sputter.

To track the switch from Risk On to Risk Off, we’ve compiled a series of charts in a publication titled S&P 500 P/E & Risk On/Off. So far this year, the S&P 500’s forward P/E peaked at 12.9 during the week of March 18. It was down to 11.9 during the week of May 18. Most of that decline occurred during the first two weeks of May, following the unsettling European election results. However, the sharp drop in the Citigroup Economic Surprise Index has also contributed to the weakness in the P/E.

Prior to the financial crisis that started in 2007, falling bond yields tended to be associated with rising valuation multiples in the stock market. The relationship has been reversed since then. Over the past five years, there has been a very high correlation between the S&P 500’s forward P/E and the 10-year US Treasury bond yield. The valuation multiple is also highly correlated with inflationary expectations embodied in the spread between the nominal and TIPS 10-year yields. There is also a strong correlation between commodity prices and the P/E. A weaker euro and a stronger dollar tend to be associated with lower stock market valuations.

Today's Morning Briefing: Train Spotting. (1) Train wreck spotting in Europe. (2) Happier tracks in the US. (3) Coal loadings are down, while other loadings are mostly up. (4) More autos are riding the rails. (5) Another green light for housing starts. (6) Intermodal loadings on schedule to pick up steam soon. (7) Q1 earnings growth rate was 8.9%, quadrupling expectations. (8) Q2 estimates are going down, setting stage for another up quarter. (9) Lots of NERIs turned positive in May. (10) A Risk On/Off primer. (More for subscribers.)

New York vs. Philly Fed Surveys

It’s the tale of two cities. Stock prices sold off sharply on Thursday last week partly because the Philadelphia Fed’s business survey was surprisingly weak in May. I’m not sure why this survey gets more attention than the other regional surveys, conducted by the Fed banks in Dallas, Kansas City, New York City, and Richmond. It’s probably because the Philly survey is among the first to come out. However, New York’s survey for May was released on Tuesday, and it was surprisingly strong.

Here’s the kicker, according to the NY-FRB: “The Empire State Manufacturing Survey is based on the same methodology and asks the same questions as the Philadelphia Fed’s Business Outlook Survey. Manufacturing companies with 100 or more employees or annual sales of at least $5 million are asked to participate in the Empire State Survey. On the first day of each month, the New York Fed sends a questionnaire to about 250 firms across New York State. Firms are added to the pool monthly to replace those that drop out. The same individual completes the survey each time, in many instances the CEO or another high-level representative. The New York Fed receives approximately 100 responses each month--roughly 90 percent via the Internet, the remainder by mail. The Fed publishes the survey results on the fifteenth of the month, or on the first business day following if that date falls on a weekend or holiday. Responses that cannot be incorporated into the report are included with revised figures released in the following month.”

Both the Philly-Fed and NY-Fed survey results are extremely volatile. They are less so when they are averaged together. When I do so for general business conditions, new orders, and employment, the May averages are down from April, but remain solidly in positive territory.

Risk Aversion Again (1) Elections upend Euro Mess cleanup efforts. (2) Debt and fiscal cliffs. (3) Earnings-led bear market or another P/E-led correction? (4) Can Europe survive a fall? (5) The “endgame”scenario is back. (6) Bank runs. (7) Another lame G8 communique. (8) The euro zone’s day of infamy. (9) “Pay me so I can pay you, or else!” (10) Better to use Greece’s bailout euros to recapitalize distressed banks. (11) Same survey shows strength in NY-Fed’s district, weakness in Philly-Fed district. (12) “Dark Shadows” (+). (More for subscribers.)

Global Growth Barometer & Fundamental Stock Market Indicator

Yesterday, I introduced a new daily indicator, Global Growth Barometer (GGB). It is basically an average of the CRB raw industrials spot price index and the price of a barrel of Brent crude oil. The S&P 500 has been very highly correlated with this barometer since mid-2008. I arithmetically modified it so that it has been useful for gauging whether stocks are overvalued or undervalued relative to the GGB. Yesterday, the S&P 500 closed at 1330.66, while the GGB was down to 1286.35. This certainly suggests that in the near term there may be more downside than upside for stock prices.

The strong positive correlation between industrial commodity prices and stock prices isn’t surprising. But why wouldn’t lower oil prices be bullish for stocks since most companies that use petroleum products would benefit? Obviously, weaker oil prices would be bearish for energy-related shares, but they account for only 11.1% of the S&P 500’s market capitalization. Apparently, investors tend to associate rising and falling oil prices with rising and falling global economic growth. That may not always be the case, which is why averaging the price of oil with a broad index of other industrial commodity prices results in a much better fit with the S&P 500 than for each of these two components of the GGB separately.

Of course, I will continue to track my trusty Fundamental Stock Market Indicator (FSMI) as well. It is also highly correlated with the S&P 500, and with my new GGB. It is weekly rather than daily. Both indicators have in common the CRB raw industrials spot price index as a component. It is probably the most sensitive gauge of global economic growth. The FSMI’s other two components are the weekly Bloomberg Consumer Comfort Index and initial unemployment claims. Both are US-centric. The FSMI is available through the week of May 5. It isn’t as bearish right now as the GGB, but it certainly confirms the recent dip in stock prices.

Today's Morning Briefing: The Greek Question (1) The Oracle of Grexit. (2) Is Greece the same as Lehman? (3) Moving more to the left. (4) Merkollande prepared to study. (5) Grexit would be “messy,” and might cost €1trillion. (6) Bank run in Greece. (7) Our new Global Growth Barometer is currently bearish. So is FSMI. (8) Can S&P 500 revenues continue to grow around 5%? (9) Industry analysts too optimistic. (10) Will global growth stay positive? (11) Retailers have had a great run. (More for subscribers.)

Crude Oil & Stock Prices



The price of a barrel of Brent crude is likely to fall to $100 soon. It is at $111 this morning, down from a recent peak of $128 on March 9. On Sunday, Ali al-Naimi, Saudi Arabia’s Oil Minister, said he wants an oil price of around $100 a barrel and would like to see global inventories rise before demand picks up in the second half of the year. He said that his country is working at bringing Brent crude prices to that level by pumping 10.1 million bpd in April, its highest in more than 30 years.

On Friday, the International Energy Agency said that oil prices are likely to stay high, despite the dramatic improvement in world supply and a big build in stocks, due to the tensions between Iran and the West. It seems to me that those tensions are diminishing because all that oil is more than replacing Iran’s exports, which have been reduced by the surprisingly effective sanctions. The Saudis are just as anxious to shut down Iran’s nuclear program as the Israelis.

Could the price of Brent fall below $100? It could if Europe’s recession worsens and depresses global economic growth. More likely is that world crude oil demand will continue to rise and that the Saudis will cut their production to peg the price around $100. World crude oil demand rose to a record high of 89.5mbd over the past 12 months through April. Demand in the Old World (the US, Western Europe, and Japan) has been relatively flat around 38mbd, while demand in the New World (everywhere else) rose to a record high of 51.7mbd in April.

I continue to monitor the CRB raw industrials spot price index daily as a very good indicator of global economic activity. This index does not include petroleum products, and gives a clearer signal about the state of the global economy than the price of oil. Nevertheless, they are highly correlated. I combine them to derive a Global Boom Bust Barometer. It’s been falling recently, led by the decline in the oil price, but remains above last year's low. The S&P 500 is highly correlated with both the price of oil and the Global Boom Bust Barometer.

Today's Morning Briefing: Fully Invested Bears (1) Lots of bearish headlines in this bull market. (2) Don’t fight the central banks. (3) The bulls are flinching again. (4) The end of the road for kicking the Greek's can. (5) Would a “Grexit” be a catharsis? (6) US cruising toward fiscal cliff? (7) Republican trifecta scenario. (8) Dr. Copper is worried about China. (9) JP Morgan’s big loss. (10) A hedge fund disguised as a hedge? (11) Moody’s is chopping lots of banks. (12) Brent for $100? (More for subscribers.)

Neverland

Welcome to Neverland! Last Wednesday, I wrote that Europe is a socialist’s wonderland. Actually, it’s more like where Peter Pan resides. Peter, as we all know, never ages and has no interest in ever growing up. He prefers the company of a tiny fairy named Tinker Bell and hangs out with the Lost Boys. There’s no adult supervision in Neverland. It’s all about eternal childhood and escapism. That sure sounds like the Europe that socialists have created and are trying to preserve. Let's join the fun:

(1) A good article on this subject, titled “What the Greek Left Wants,” appeared in last Wednesday’s WSJ. The author is a columnist for protagon.gr. His main conclusion about the Greek elections held a week ago is that “[w]hile austerity measures did play a part in voter discontent, the most important factor in the outcome of the elections was opposition to any talk of structural reform of the Greek economy.”

He observes that Syriza, the radical left party, ended up in second place largely because it promised to maintain the status quo: “The Greek left today does not represent an industrial proletariat that wants a bigger share of the economic pie. Syriza represents all the groups that have been able to grow and flourish under Greece's political system and who now feel threatened by reforms. It derives its support from various professional interest groups--lawyers, teachers, journalists and civil servants--who feel that their jobs and special privileges are at risk if Greece is forced to open up its economy to competition.”

(2) The only adult supervision in Europe’s Neverland seems to be coming out of Germany, particularly Chancellor Angela Merkel. Last Thursday, she rejected calls from her center-left opponents in Germany and Europe for economic stimulus policies that rely on new debt. In a speech before the Bundestag, she admonished, “Growth through structural reforms is sensible, important and necessary. Growth on credit would just push us right back to the beginning of the crisis, and that is why we should not and will not do it.” Yesterday, Merkel suffered a major blow after voters in Germany's biggest region, North Rhine-Westphalia, rejected her austerity policies, raising doubts that her government can stay in power after next year's general election.

(3) In her speech, the German Chancellor seemed to be responding to Italian Prime Minister Mario Monti’s call on Wednesday for a “new compromise.” In other words, he wants to add more deficit-financed spending to the fiscal austerity pact that 25 of the 27 leaders of the EU had agreed to at the end of last year. He wants to see more public spending on large infrastructure projects. He added that his proposal was aimed at "winning over German minds and, what's more difficult, German hearts."

Monti’s comments might also have been aimed at winning over Italian hearts and minds. In local elections in Italy on Sunday and Monday of last week, the vote saw heavy losses for the center-right PDL, a key party in his majority, and big gains for opposition parties, including The 5 Star Movement, which campaigns for Italy to leave the euro and default on its debt.

(4) Last Tuesday, Monti called for changes in EU budget rules to allow governments to pay outstanding bills to the private sector without pushing up their budget deficits and for greater distinction between public investments and other types of spending. Reuters reported: “The issue of late payments by the public sector is under the spotlight in Italy, where firms are being squeezed by a lack of liquidity and the state is notoriously slow in settling bills with the private sector, estimated at least 60 billion euros. Monti said budget deficit calculations should distinguish between ‘virtuous’ public investments and less productive state spending, something so far resisted by Germany and some other northern European countries.”

(5) This morning’s Washington Post reports: “Greece appears headed to new parliamentary elections next month, further delaying its efforts to meet international demands to overhaul its economy, after leaders of the country’s major political parties declared little hope Sunday for a last-ditch effort to form a coalition government. The failure of the leaders to pull together a coalition brings Greece one step closer to leaving the 17-country bloc that uses the euro currency, although much will depend on the new elections.”

(6) In other words, the Europeans want to grow, but they don’t want to grow up. They want to play accounting and other games. The unruly crowd is ignoring the sensible, but stern admonishments of Frau Merkel. She might have to cut off their allowance. As the WSJ notes today: “By next month, Athens must identify €11.5 billion, or $15 billion, in fresh spending cuts or face suspension of the international loans it needs to pay pensions and run schools. If it doesn't get the money, it would eventually have to print its own.”

Today's Morning Briefing: Sweet & Sour (1) Central bankers making smoothies. (2) A spoonful of sugar. (3) A bad aftertaste. (4) A sweet batch of US indicators. (5) PBoC acts fast to pump up credit. (6) Wunderbar: Germans rejecting austerity, accepting higher inflation risk! (7) Japanese lawmakers stacking the BoJ’s easy money deck. (8) Global economic slowdown taking some air out of stocks and commodities. (9) Still staying home for now. (10) “The Avengers” (-). (More for subscribers.)