Love ‘em or hate ‘em few have ridden the recovery rally as well as JP Morgan’s equity team.  They continue to trade the rally from the bullish side (and the correct side).  They say the strength of the recovery is underestimated and skeptical investors will slowly continue to pile into risk assets.  Of course, they aren’t the only big bank with a very positive outlook.  BlackRock recently released very similar commentary.

Just a few weeks ago JP Morgan said the concerns about China’s tightening and Greece’s debt fears were overblown and investors should buy the dip (see here for more).  But this doesn’t mean there aren’t continuing risks to their outlook.  Among the main risks are the following:

• Premature policy tightening
• Unfinished delevering.

In terms of strategy, they are getting more and more aggressive.  They like Greek government debt, US small caps and a tactical long in oil:

• Fixed income: Close shorts in US 2s, but stay short in the UK. Buy Greek government debt.

• Equities: Stay long, focused on small caps and cyclical sectors. We are reluctant to overweight EM equities despite their higher beta.

In order of importance, we like most equities (small caps and cyclicals), then higher-yielding credits, followed by commodities (base metals), and rounded off with a small long in US HG. This strategy is not mega bearishbonds, where we trade tactically from the short side.

• Credit: Investors are becoming more bullish US HG spreads but have yet to adjust their positions. Stay long US HG.

• FX: Take profit on long USD positions against EUR, GBP, and commodity currencies.

• Commodities: Stay long commodities, favoring base and precious metals near term.  They have a $90 year-end target on oil

Source: JPM

1) Total job losses were just 35K versus expectations of -50K. We mentioned that jobs growth would return in Q1 and there is little doubt in my mind that this number would have been in the green were it not for the Winter storms. Of course, the more important aspect of this jobs rebound is to keep it in perspective. We lost 7MM+ jobs during the course of this recession. Using the prior recovery as framework, it would take 86 months (2016) to get back to where we were before the recession began. The last jobs recovery was nothing to sneeze at.  If you recall, it was the one thing President Bush continually hung on as an economic positive.  This is going to be a long recovery folks.

Don’t get too excited about these “better than expected” jobs reports. In the grand scheme of things there is still a lot of pain out there on Main Street. The jobs data has more interesting implications, however. We’re now seeing a troughing in unit labor costs.  This has been the largest cost cutting operation in corporate America since 1948.  It’s been truly remarkable and corporations should be commended for staying lean and prudent.  It’s coming to an end though.

Unfortunately, this means corporations are no longer cutting costs via employment cuts at the rate they have been. While the cost cutting has been a good sign, this turn in labor costs will hurt profit growth going forward barring a sizable return in revenue growth (revenues grew 1.1% ex-financials last quarter). As we’ve mentioned previously, this is shaping up to be a year that is characterized by H2 earnings disappointments. This jobs data (as it turns positive) supports this thinking. Interestingly, analysts are boosting their estimates at just the wrong time (as the rebound in corporate profits begins to slow its pace).

The jobs data also has important implications for the Fed. This positive jobs report means the Fed is going to be encouraged and pressured to raise rates & end their liquidity programs sooner rather than later. While global rate increases have already started its likely that Bernanke will begin to feel the pressure due to the improving employment situation. As previously noted, tightening phases are rarely a positive for stocks.

2) A big part of me wonders if the only viable trade in this market isn’t to ride the coattails of JP Morgan, BlackRock, Goldman Sachs and the other big banks who have been driving liquidity via their gifts from the Fed. All of them have targets of 1200+ on the S&P 500.

3) We haven’t had a short bias (except for one brief short in June of 2009) throughout the duration of the 70% rally. With sentiment turning overwhelmingly complacent in recent weeks and a deteriorating earnings outlook I feel comfortable moving to a medium sized short bias on the back of today’s bullishness.  The Russell 2,000 has rallied over 16% on the back of a move that has taken it higher in 16 of the last 18 sessions.  This is high beta greed at its best.  Even more remarkable is the move down in the VIX.  The VIX has now traded lower in 17 of the last 18 sessions and is spiking lower as the Russell hits a new high.  I am approaching this in the same manner in which I approached the June position – with the understanding that the upcoming earnings season is likely to be positive (there is at least 1 more quarter of very easy analyst comps) and investors will account for that appropriately.  Although the risk/reward isn’t perfectly ideal these are the kind of situations I lie in wait for.

Analyst’s at JP Morgan are telling equity investors to ignore the bad news coming in the next month as most of it is likely due to the bad weather across the United States.   They are encouraging investors to maintain belief in their recently renewed bullish stance (see here) on the equity markets and not overreact to the downside:

“The next month’s worth of economic data will be full of weather and lunar new year distortions. This will create a lot of confusion, but should also persuade investors not to overreact to data noise. We fully agree, and choose to stay with our medium-term strategy of overweighting equities, commodities, and credit, and trading bonds from the short side. Positions changes should be based more on intrinsic value, taking assets from more nervous market participants, than on short-term market direction.”

Due to the coming likelihood of downside surprises in economic data JP Morgan is taking a longer-term outlook when it comes to the equity markets.   They remain overweight equities, commodities and credit.

• Fixed income: Take advantage of the rally to reset shorts in US 2s. Sell Agencies against Treasuries.

• Equities: Stay long, focusing on small caps and cyclical sectors. Euro area underperformance is unlikely to be reversed.

• Credit: Overweight HY loans versus bonds in CDS indices as their spread is cheap versus the much better recovery rate on loans.

• FX: There is a near-term bias for EUR to reach the low $1.30’s.

• Commodities: We turn medium-term bullish on oil.  WTI is expected to rise to US$90 by year-end.

Source: JP Morgan

David Rosenberg isn’t going down without a fight.  The staunch bear believes the market is looking “toppy” and is displaying many of the characteristics of the 2007 market highs.  In a strategy note this morning, he notes the declining rate of change in the S&P 500:

“The S&P 500 has basically been hovering around the 1,100 threshold since October 15, getting as low as 1,042 and as high as 1,150 in what can only be described as a tight 10% band. (As an aside, the 13 week rate of change for the S&P 500 has swung to negative territory.) It has split the time above and below the line almost perfectly evenly as well (52% above, 48% below). We can understand the emotions involved in such a prolonged sideways band — a down move to 1,080 triggers calls for a correction, while moves up back to 1,120 prompts calls for a new high coming around the corner.”

He says today’s market is very similar to 2007 when we hovered near the highs for several months before tipping over.  He claims the economic data supports a market top here:

“In a secular bull market, a six-month trading range can be viewed as a pause that refreshes. But in a secular bear market, it more than likely reflects a classic topping formation, as was the case in the spring and summer of 2007 when the S&P 500 also flirted with the 1,500 mark for as long a period as it has hovered around the 1,100 threshold since last fall. Keep in mind that similar to 2007, we are starting to see some fraying around the edges in the latest set of economic data releases — jobless claims, housing starts and sales, core goods orders and shipments, construction, ISM and consumer confidence.”

Source: Gluskin Sheff

In a recent strategy note Morgan Stanley’s equity team says it is too early to purchase stocks.  According to their analysts the risks remain too numerous to ride the recent uptrend in stocks.   They say we are tracking the 1994 and 2004 recoveries and the two years suffered through several quarters of range-bound and lower prices.  Both years, the market stumbled as investors tried to digest the beginning of the Fed’s tightening.

As we’ve previously mentioned, MS believes the global tightening phase has already started (see here).   MS says this is creating a “growth scare” that could eventually result in a double dip.  All of this is creating a high level of uncertainty that will keep the market under wraps.    They believe the uncertainty will last for several more months or quarters and ultimately result in a better buying opportunity.

“Fundamental headwinds remain from policymakers shifting to tightening mode, moderating growth prospects and higher uncertainty generally (including sovereign concerns). We would like to wait for more clarity on these issues e.g. an easing in Asian inflation fears, a change in Fed language being out of the way and some re-basing in growth expectations. We will keep in mind the key 1994/2004 levels on growth indicators such as negative readings on the ECRI and earnings revisions or a 10-15 point correction in ISM new orders.”

Source: MS

As the Q4 2009 earnings season comes to a close it’s important to take a look at the overall earnings picture.   With over 98% of the S&P 500 reporting it looks like Q4 earnings will come in a little shy of $16.80.  As we fully expected the analyst’s estimates once again proved to be well below the mark as 72% of all companies outperformed expectations.   This has resulted in substantial estimate increases and has been one of the primary reasons why we have maintained that investors could not short this market for the entirety of the last year.  The earnings upgrade cycle has served as wind at the market’s back, but the optimism is now becoming an impediment.

In the last year analysts have substantially contributed to the equity rally as they upgraded stocks and increased their estimates.  The “Monday upgrade” rally has become a hallmark of the move higher in stocks as analysts spend their weekends adjusting estimates and preparing for Monday morning upgrades and downgrades (though mostly upgrades).   In just the last 8 weeks analyst’s Q1 2010 estimates have jumped 4%.   In addition, they are growing increasingly optimistic about the latter portion of the year (where I believe things get potentially messy).   The H2 estimates have continued to creep higher as Q4 earnings were released.  Analysts are now calling for $78 in operating earnings for FY 2010.  The 2011 estimates have also surged.  Analysts now expect $94 in operating earnings for 2011.  That would represent back to back years of 20% earnings growth - something that has never happened before in the history of the United States equity market.

The real problems lie in the latter portion of 2010.  Analysts are currently calling for 38% year over year growth for Q2, 30% year over year growth in Q3, and 27% growth in Q4 2010.  Granted, these are coming off of easy comps, however, we have yet to see any real revenue growth.    Including the very easy comps with financials, sales grew just 5% year over year in Q4.  If we exclude the financials revenue growth was nearly non-existent at just 1.1% year over year.   This is best visualized in the image below which shows the S&P 500 by revenue per share.  The trough is clear, but there is certainly no v-shaped recovery here.  At best, we are bumping along the bottom.

We are well into the economic recovery (ISM at 5 year highs and record highs in the ECRI’s leading indicators) and the ultimate L-shaped recovery remains in corporate revenues.  The vast majority of the rebound in earnings is non-organic and unsustainable.  Margins have expanded to pre-crisis highs as companies squeeze every last drop down to the bottom line.  Analysts expect earnings to return to near 2007 levels without any real revenue growth.  I find that hard to believe.  If you’re still confused as to why insider buying is non-existent in this market look no further than the revenue line of corporate income statements.

As sentiment has becomes very optimistic in recent weeks the Expectation Ratio has taken a bit of a spill.  The ratio peaked in the back half of 2009 along with the market and is now forecasting a far more difficult future for corporate earnings.  Without a substantial acceleration in revenues it is unlikely that this market is headed anywhere fast.  While it looks as though we likely have one more quarter of very easy earnings comps (Q1 2010) the real test will come in the latter portion of the year where estimates are extremely optimistic.   With little to no signs of organic growth I find it hard to believe that the bull market in earnings can continue.  That will serve as a major hurdle for the equity markets in 2010.*

*  The ER is a longer-term indicator that not only forecasted the 2007 & 2008 downturn, but also forecasted the 2009 bottom in stocks well in advance.  It’s a cyclical indicator and should be viewed with a bit of a longer time horizon.

Investors Business Daily has updated their market outlook from negative to positive.  In justifying their strategy change they note the S&P 500’s move above the 50 day moving average, strength in important sectors such as tech, and the increasing number of new highs.  This leads them to believe institutions could be more active buyers of equities in the coming weeks.

Using history as a precedent, they see Monday’s rally as an encouraging sign for future returns:

“There are some encouraging precedents for Monday’s follow-through.  In 2005, the market posted two follow-throughs that came with index gains of about 1.5% or 1.7%.  Those May and October moves produced meaningful market advances.”

Perhaps most important is strength in China, which has no doubt been the engine of the global recovery.

“Another positive note came from the market in Hong Kong, which staged a follow-through of its own Monday. Anumber of Chinese stocks rallied Monday and are U.S. market leaders.”

Nonetheless, they don’t appear to have the same conviction they have had with some of their past bullish calls (which included a March ‘09 buy call).  Specifically, they are concerned about the weak gains during the recent rally as well as the poor accumulation levels.    This makes the rally particularly susceptible to breaking down:

“Although the market has made a bullish signal, questions remain, partly because Monday’s index gains weren’t so lofty.  The NYSE, S&P 500 and Dow still have poor Accumulation/Distribution Ratings.  Market uptrends always begin with a follow-through, but not every follow-through works.”

Source: IBD

The Fed’s surprise discount rate move has investors searching for reassurance on the  interest rate outlook.  Yesterday’s comments from Ben Bernanke were enough to spark a 1% rally in the equity markets based on the hope that the Fed will remain accommodative for many more months.  Morgan Stanley’s equity team says this bullishness is unwarranted.  They believe the global equity tightening phase has already started and the United States is simply lagging.  As we mentioned last week, MS recommends selling rallies during the tightening phase (see the full year bearish 2010 outlook from MS here).  As the global tightening phase deepens they fear a “growth scare” could develop:

“From ‘start of tightening’ to ‘growth scare’.  While leading indicators are rolling over, we expect a period of lower growth prospects, higher uncertainty and possibly higher rates as overheating fears in Asia, start of Fed exit in the US, and sovereign trouble in Europe will dominate.  Our 10% 2011 EPS growth estimate for Europe is below the 24% consensus estimate.

Sell the rallies until fundamentals improve, or our indicators say ‘buy’. Fundamentals should improve, we think, when Asian inflation pressures ease, the Fed language change has happened, and sovereign contagion risks recede.”

Historically, the beginning of tightening phases have resulted in several quarters of equity market weakness.  Using the 1994 and 2004 recoveries as framework MS finds that double digit corrections were characteristics of both tightening phases.

“We have found that this ‘start of tightening’ phase coming out of a recession (such as 1994, 2004) always leads to a period of 2-3 quarters of struggling equities, including a double-digit correction.  This is now morphing into a growth scare, we believe.  Our earnings growth leading indicator still suggests strong growth in 2010, but we expect 2011 EPS growth to disappoint at 10% versus consensus expectations of 24%.   In addition, leading indicators are peaking out and rolling over right now.  This is typically followed by struggling equity markets.”

On a more macro level they continue to believe the secular bear is alive and well and now see 5 themes that could coincide with the next global recession:

“We think the secular bear market that started in 2000 is still due its final leg, in the next global recession.  This next global recession is up to a few years away still, we think, when EM/China growth falters, although sovereign contagion could cause the next global recession sooner.  The next recession could involve problems relating to high inflation, sovereign funding in G7 countries, a China recession, a much higher gold price, and the Shiller P/E undershoot that did not happen in 2008/09.”

Based on this overall outlook Morgan Stanley believes investors should continue to sell the rallies until equities correct to a more attractive level:

Sell the rallies … We believe 1994 and 2004 are recent years that were similar to what we expect to go through this year. Equities had many ‘swings and roundabouts’ those years, but the right strategy was to sell the rallies when the tightening and growth scare phase had started, which we believe was in
mid-January.

Source: Morgan Stanley

The latest from Goldman’s Chief Economist, Jan Hatzius, is not exactly a ringing endorsement of the stock market (see their 2010 outlook here & their top trades for 2010 here).  Hatzius says the recovery is likely to continue to be very slow and that unemployment is likely to spike higher in the near-term accompanied by little to no inflation.  Hatzius claims that the second half recovery in 2009 was entirely driven by the stimulus and inventory restocking.  In other words, it is nothing to get excited about as neither are sustainable trends.   What concerns Hatzius most going forward are 5 continuing negative trends:

1.  Continued saving by households

2.  Weak labor income

3.  Fiscal drag from states and local governments

4.  Vacant homes and unused industrial capacity resulting in low private sector investment

5.  Limited credit availability

Although the labor markets are showing signs of improvement in recent weeks Hatzius sees a continuing “jobless recovery” and persistent weakness into 2011.  He is calling for a climb in the unemployment rate from the current level of 9.7% to 10.5%.  He continues to believe inflation will remain well below trend and that the Fed is on hold for the remainder of 2010 AND 2011.

Based on this data Goldman is now calling for just 1.5% growth in GDP in the second half of 2010.

Tim Bond of Barclays has been remarkably accurate in predicting the strength and length of the global equity rally.  Despite the many signs of weakness over the last 9 months Bond has remained very optimistic (read his bullish note from 2009 here).   He claimed that analyst estimates and high levels of bearishness would lay the foundation for a continuing equity rally.

“Never has a bull market climbed a steeper wall of worry. Despite a proliferation of positive economic indicators, the consensus remains resolutely gloomy. Bullish economists are still rarer than hens’ teeth. The average forecast for Q3 US GDP growth is an anaemic 0.8% increase, which would be by far the slowest first quarter of any recovery on record.”

He couldn’t have been much more accurate.  The economic landscape is quickly changing, however, and Bond’s outlook is turning decidedly less optimistic.  Bond now believes the problem of debt is becoming contagious in Europe and that higher bond yields will accompany the process:

“Fiscal dynamics point towards higher government bond yields in many economies, including the UK and US.  History is unequivocal in linking fiscal deterioration to higher yields.  This point is clearly becoming recognized by investors.  As a result, a contagious process has started, during which risk premia in bonds, equities and currencies adjust higher to reflect the fiscal situation.  This process is unlikely to remain confined to southern Europe, but will eventually embrace all those economies with sizeable budget deficits.”

Bond has argued for much of the last year that low rates and de-leveraging were actually very bullish for equities.  As monetary policy begins to shift and fiscal policy remains imprudent the landscape is shifting.  Like Teun Draaisma, Bond is concerned about the impending higher rate environment that will accompany global rate increases and continuing risks associated with an indebted global economy.  Bond argues the long-term situation remains unfavorable for 3 primary reasons:

1)  The majority of the G20 is a fiscal mess

2)  Demographic trends of the G20 are highly negative

3)  Containing the long-term government debt problem will be painful

Most alarming to Bond, however, is the close relationship between high debt levels and rising rates.  In studying 6 developed nations over the last 20-30 years, Bond found that a 1% change in deficit/GDP caused a 32 bps increase in 10 year rates.  Based on this, Bond says we are due for a substantial rise in global rates.   This “abruptly” deteriorates the outlook for equities:

“The analysis also reinforces our standing recommendation to ratchet down equity risk in the current quarter, in expectation of corrective behavior in Q2 and Q3.  The timeline we had in mind is being accelerated and a contagious process is already underway.  To be sure, such an approach might be overly cautious and premature.  There is an obvious risk of missing out on further gains from the liquidity fueled portion of the bull run.  Some investors will undoubtedly  wish to continue dancing on the edge of the volcano and we wish them good luck.”

Source: Barclays