Reasons for Optimism: Equity Thoughts and Forecasts for Q4 2010

“…the big money was not in the individual fluctuations but in the main
movements, in sizing up the entire market and its trend…nobody can catch all
the fluctuations. In a bull market your game is to buy and hold until you believe
that the bull market is near its end.”1 Jesse Livermore

These observations were made nearly a century ago, yet they are as relevant today as they
were then. In adopting Mr. Livermore‟s approach and „sizing up the entire market and its
trend,‟ I still believe we are in a bull market. As such, our game should be to „buy and
hold until (we) believe that the bull market is near its end.‟ Furthermore, we must accept
that we cannot „catch all the fluctuations‟ the most recent of these being the ~17% stock
market dip over the summer months. That corrective phase has at least paused and is, in
my view, entirely behind us. As JP Morgan‟s Jan Loeys put it, the subsequent global
rally in September was not built on signs „that the world economy improved. It did not.
The good news was simply that the economy
stopped getting worse.‟2 Core Reasons to be
It is true that over the last several months the Bullish
supporting arguments have shifted, while the
general conclusion of being positive on
equities has remained unaffected (thereby
risking the label of perma-bull). Regardless,
this stance is currently built on four core Loose Monetary Policy
conditions:
Attractive Valuations
1) Loose monetary policy
2) Attractive valuations De-Equitization
3) De-equitization
4) Pessimistic sentiment and positioning Pessimistic Sentiment

This piece discusses, in turn, each of the supporting arguments to the bullish thesis and
closes with a synopsis of the risks. Lastly, in
Model Portfolio Allocation
an attempt to clarify exactly what an outlook
means for asset allocation purposes, I introduce Neutral Recommended
Allocation Tactical Target
a Model Portfolio Allocation. The current
Fixed
positive outlook on stocks is expressed in a Income 35% 25%
tactical overweight of equities versus bonds. Equities 65% 75%

1
Reminiscences of a Stock Operator, Edwin Lefevre –a thinly veiled biography of Wall Street legend Jesse Livermore
2
JPM – Global Markets Outlook and Strategy, October 6, 2010

October 11, 2010 Page 1 of 8 Tyler S Lang, CFA, CMT

Loose Monetary Policy

The pressure on central banks to tighten earlier in the year has been replaced by exactly
the opposite: pressure to ease further. This shift in sentiment from a tightening bias
toward loosening was driven by poor economic data over the summer months. Beginning
with Bernanke‟s speech in Jackson Hole on August 27 and continuing through
September, the Fed made it rather clear they are willing to step in and reflate the
economy in order to avoid a double dip. One interpretation of Fed Policy comes from
Bloomberg‟s Rich Yamarone:

During the Sept. 21 meeting of the FOMC, the Fed said, "Measures of underlying
inflation are currently at levels somewhat below those the Committee judges most
consistent, over the longer run, with its mandate to promote maximum employment and
price stability." This is Fed speak for "We are closer to deflation than any other time in
post World War II history, and we aren't going to let it happen under our watch."

Since it is impossible to go
below zero percent on short
term rates, the Fed „eases‟ by
adding more Quantitative
Easing (QE) or as they now
call it, Large Scale Asset
Purchases (LSAPs). This
diagram from Bloomberg,
which displays the three ways
the Fed is encouraging risk
taking behavior of market
participants, appears more
relevant than ever. In other
words, they are pushing
investors (kicking and
screaming) to move further out on the risk spectrum…out of treasuries and into high
yield credit or equities. Irrespective of whether their efforts will be successful, a first
order effect of this commitment toward reflation is a risk asset rally. Thus, (ultra) loose
monetary policy remains the number one reason to be bullish on stocks.

October 11, 2010 Page 2 of 8 Tyler S Lang, CFA, CMT

Attractive Valuations

There are several ways to approach valuation, most of which are pointing to a stock
market that is trading at attractive absolute and relative valuations. As discussed in the
Q2 outlook and shown in this
equation to the right, the
current market price is made PV of PV of Current
Current Growth in Price of
up of two components: 1) the Earnings Earnings S&P 500
PV of trailing 12 month EPS
into perpetuity and 2) the PV
of earnings growth.

Currently, the
market is pricing in
negative earnings
growth for the S&P
500 because the
present value of
current earnings is
15% greater than the
current value of the
S&P 500! See the
chart to the left from
Citi.

Looking at equities relative to bonds, the S&P 500 earnings yield is currently 6.6% while
ten year BB yields are trading at 6.76%. (BB is the second highest notch of „non-
investment grade‟ bonds) This is rather unusual and speaks to the „cheap‟ relative value
of stocks versus bonds.

Concurring with this BB Yield minus S&P Earnings Yield

assessment are recent 4.000%

comments from Warren 3.500%

Buffet on CNBC, “It‟s quite 3.000%
clear stocks are cheaper 2.500%
than bonds. I can't imagine 2.000%
anybody having bonds in 1.500%
their portfolio when they 1.000%
can own equities, a 0.500%
diversified group of 0.000%
equities.” 2003 2004 2005 2006 2007 2008 2009 2010

October 11, 2010 Page 3 of 8 Tyler S Lang, CFA, CMT

De-Equitization

In stark contrast to the aggregate over-leveraged balance sheet of the American

consumer, corporate America sits on a conservative, cash rich balance sheet. What‟s a
corporation to do? There are really only a few options for a corporation with excess cash
on the balance sheet: do nothing, invest (capital expenditures or hiring), acquire, or return
to shareholders (dividends or buybacks). Corporations are doing and will continue to do
all of these things with their cash. The option that is increasingly attractive and probably
has the largest impact on equities is share repurchases.

De-equitization isn‟t just about companies using excess cash to buy back shares, it also
occurs when companies issue debt for share repurchases. Contrasting corporate America
once again with the American consumer, we see that corporations, on the whole, have
access to plentiful and cheap credit. In many cases, it is profitable for a company to
access the credit markets to sell expensive debt and use the proceeds to buy back less
expensive equity. In doing this they are realigning their capital structure, lowering their
Weighted Average Cost of Capital (WACC), and instantly boosting ROE (by decreasing
the denominator more than the numerator in the equation: Net Income / Equity).

De-equitization is the general idea of corporate balance sheets being a large

incremental buyer of equities. Given the benefits of the strategy and the current
position of corporate balance sheets, it seems likely that this trend will resume after
pausing 2009. Such a development would provide additional support to stock prices.

October 11, 2010 Page 4 of 8 Tyler S Lang, CFA, CMT

Pessimistic Sentiment & Positioning

July and August saw sentiment indicators hit deeply pessimistic levels. One might expect
September‟s 8.76% rally to instill confidence, but focusing on measures that indicate
what investors are doing, rather than what they may be saying in polls, it appears they
continue to view equities with healthy skepticism. When there is persistent doubt in the
face of a rising market that is often contrarily positive for equities.

As a general rule,
Equity Mutual Fund Flows Bond Mutual Fund Flows
investors in equity mutual
$50,000
funds have the art of Net Buying
$40,000
timing down to a fine
$30,000
science…Buy high and
$20,000
sell low. To the right is a
$10,000
chart of mutual fund
$0
flows from ICI, which ($10,000)
indicates that investors ($20,000)
are selling their „risky‟ ($30,000)
Net Selling
equities and buying „safe‟ Jan Feb Mar Apr May Jun Jul Aug Sep Oct
Source:
bond funds.

Short Interest data from Bloomberg shows that investors have continued to short stocks,
even as prices climbed in September. This indicates that investors continue to be
skeptical on the durability of the rally and they are positioning accordingly.

October 11, 2010 Page 5 of 8 Tyler S Lang, CFA, CMT

The last sentiment measure is the Panic/Euphoria Model from Citi‟s strategist, Tobias
Levkovich. He does not divulge the exact inputs but taking it from his description as
being a measure of how „investors are positioning themselves‟ (as opposed to what they
are saying), it is particularly interesting that this remains in panic territory.

The fact that these measures indicate that investors are bearishly positioned contrasts with
several sentiment polls that show investors are optimistic. It is indicative of an
environment where market participants are saying one thing but they are not backing up
their words with actions. At such times, it seems rational to put heavier weight on
indications of how investors are actually behaving. In other words, talk is cheap.

Anecdotal conversations concur with this lack of belief in a stock market rally. Ask a
bearish tilted investor at what point they throw in the towel and cover or move to a
neutral allocation: when we hit new highs? When we get to 1,300? My experience has
been that they don‟t have an answer, which is probably indicative of a high level of
confidence in their negative tilt. Perhaps they will be correct, but the fact remains that
investors on the whole are rather vulnerable to a rally in stocks and that creates the
potential for higher prices leading to still higher prices. George Soros would call this
reflexivity, while others might describe it as a momentum driven market. Regardless,
markets have a tendency to sniff out vulnerability and punish it. All of this adds up to a
market condition of there being more incremental buyers than sellers and that is, on
balance, bullish.

October 11, 2010 Page 6 of 8 Tyler S Lang, CFA, CMT

Risks

Federal Deficit
One of the largest risks right now is the size and direction of the federal deficit. It is like
a giant super tanker
heading toward a rocky
shore. Some solace
comes from the fact that
we have been at worse
levels before, albeit,
never in peace time.

Getting this under

control or at least
developing some ideas
for how to start heading
in the right direction
would reduce some
anxiety around this
looming risk. The bi-
partisan National
Commission on Fiscal
Responsibility and
Reform was charged
with advising on this
topic. The good news is
that both democrats and republicans are still at the table. The real test comes on
December 1, 2010 when the commission must issue its full report.

If a convincing
solution is not
proposed or if its
implementation
seems implausible,
most investors judge
that would negatively
impact equities in 2Q
or 3Q of next year.
(Source: CIRA – US
Equity Strategy)

October 11, 2010 Page 7 of 8 Tyler S Lang, CFA, CMT

Long term inflation
An increase in the Fed‟s balance sheet from higher QE/LSAPs, ultimately increases the
risk of an inflation blowout in several years. Also, it raises the perception that the Fed is
monetizing the debt, which decreases demand for treasuries.

Other Risks
This is how a survey of Institutional Investors from Citi ranks the current risk landscape.

This is how institutional investors view „tail risks‟ from BofAML‟s Fund Manager
Survey:

October 11, 2010 Page 8 of 8 Tyler S Lang, CFA, CMT