is the wall street party ending soon? -...

US indexes are seeing consecutive monthly gains in a resolutely optimistic environment. Buoyed by strong corporate 4Q earnings and the assurance the Fed will continue its asset repurchases, S&P 500 index is just a few points shy of establishing a historic high. In retrospect, the stalemate Italian election was the most attractive buying opportunity for US investors since the turn of the year. Before we jump on the bandwagon, it is best to delve deeper at the factors driving the rally, and the sustainability of the strong-run.

Victor WaiInvestment Analyst(+65) 6531 1517 [email protected]

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19 March 2013

Is the Wall Street party ending soon?

Chart 1: S&P 500 and DJIA performances

Source: Bloomberg, Mar 13, 2013

Highlighted in red are periods of US recession.

Since breaking out of recession in 3Q2009, S&P 500 (black) has risen close to 68%.

DJIA (yellow) has set record-high in recent trading days.


19 March 2013

Unemployment (red) moderated to 7.7%

Personal savings/ disposal income (blue) decreased, suggesting consumers are spending

Consumer confidence (green) trends higher.


Chart 2: US consumers are spending

Investors should remember that the S&P 500 hit a record-high in Mar 2000 with 1,527 points before tanking 20% the following year. Less than six years ago, the index reached an all-time high in Oct 2007, only to take a 42% dive a year later. Although pastperformance is not necessarily indicative of future performance,the economy was in much better shape on the 2 previous occasions when S&P 500 peaked than it is now. The current unemployment rate is stubbornly at 7.7%, while unemployment rate was 3.9% in 2000 and 4.7% in 2007. Having contended unemployment rate in excess of 10%, unemployment rate at 7.7% is not too bad a figure, or so it seems to investors. Hence, investors are encouraged by the improvement since the depth of the financial crisis.

Equities and inflation share an intricate direct relationship. As residual real claims on businesses, common equities offer some form of protection to inflation as compared with conventional bonds. However, should companies unable to pass on the higher input prices to consumers, corporate earnings may suffer. At 1.6% y/y, inflation has not threatened corporate returns. It is still an open question if the Fed’s open-ended monetary stimulus of $85 billion asset repurchases monthly will sufficiently drive down unemployment rate while keeping inflation at bay. Following the latest release of the Fed’s meeting minutes which revealed a divided committee on the Fed’s stimulus policy, S&P 500 sank nearly 2%. Thus, the upcoming Fed meeting on March 20-21 may conclude with a decision to scale back the amount of asset repurchases, reversing the upward trajectory of the stock market which has become reliant on the hot money pumping into the economy.

Dow Jones Industrial Average (DJIA) and S&P 500 registered their biggest drop year-to-date with the inconclusive Italian election, with the Italian majority clearly rejecting austerity measures. The widely regarded “fear index” CBOE Volatility Index lifted off its lows with the Italian political gridlock, albeit for a brief few days. While most European bourses have not recovered from the Italian election shock, US benchmark indexes have set their multi-year highs. The inverse relationship between the fear index and equities, as shown in Chart 3, is obvious. Hence, at the current VIX level, the probability of general market correction is higher than equities continuing their ascension.


19 March 2013

Most S&P 500 companies have turned in decent 4Q results, which is consistent with what Chart 2 suggests (domestic consumption improving). At the same time, major banks are streamlining their operations, often with significant manpower cuts. Despite reporting company-record profit of $21.3 billion in 2012, JP Morgan Chase plans to cut 17,000 jobs by 2014. In addition, according to ConvergEx, mergers and acquisitions spending is up $219 billion this year, compared with $85 billion the same period a year ago. Evidently, corporate fundamentals are paving the way for stocks to march higher.

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19 March 2013

S&P 500 Index (blue) and CBOE Volatility Index (red) exhibit inverse relationship.

CBOE Volatility Index slumped to its lowest level since Feb 26, 2007 while S&P 500 is within touching distance to its all-time high.

Chart 3: Inverse relationship between Volatility and equity returns

Deeply troubled “Club Med” economies of southern Europe are back to the headlines once again, as the 3rd largest European economy political stability remains an enigma. Without a Prime Minister, Italy is somewhat lost in Europe, whether to seek aid or continue its austerity reform in a bid to reduce its 2 trillion euro debt. Spain’s Partido Popular (Popular Party) continues to come under public scrutiny over a corruption scandal, at a time when the economy is nursing its busted property bubble.

Cyprus stole the limelight in recent days when small banking depositors may be levied with a tax, in a bid to rescue Cypriot financial system from a collapse. Meanwhile, Greece at the quiet eastern end contracted 5.7% in 4Q2012. In short, eurozone is still a region fraught with multiple financial and political risks, in spite of ECB’s “whatever it takes” pledge. Moreover, restructuring the EU banking system may take several years. In the months before Germany’s election in September, any negative news will likely check US equities’ advancement.



“We can always count on the Americans to do the right thing, after they have exhausted all other possibilities,” quoted Winston Churchill. Indeed, global markets rejoiced when the largest economy managedto pull itself back from the cliff on New Year’s day. The Congressional Budget estimates that the new tax codes would raise taxes on 77.1% of US households - on average an increase of $1,635 per household. Although a major uncertainty (fiscal cliff) has been removed, it seems that the market has not priced in the likely decrease in consumption. As shown in Chart 4, US real disposal income plunged in the negative territory in January. Despite recent improvement in core retail sales, we are concerned with the sustainability of consumer spending in the following months.

Chart 4: US real disposable income (% MoM)

The US debt ceiling has been reached, but it will be suspended till May 19. In the previous round of debt ceiling negotiation in summer 2011, S&P downgraded the sovereign credit rating of the world’s largest economy. In view of the likely political posturing between the Democrats and Republicans, it seems that investors have not priced in the likely scenario of a US default in a little more than 2 months.

19 March 2013

Household income might succumb to weakness going forth should real disposable income remain negative.


19 March 2013

Chart 5: US government debt to GDP

US has reached the $16.4 trillion debt ceiling.

Salaries of lawmakers are suspended as part of delaying debt ceiling negotiation.

Source: US Bureau of public debt

Equity prices seem to have decoupled from economic fundamentals. With the US economy expanding at a mere 2%, and a rising public debt to resolve, corporate fundamentals and accommodative monetary policy may not be able to sustain the party Wall Street is throwing. Market correction is highly probable in the near-term. However, value stocks with stable dividend yields can weather the volatility as it comes. Investors are less likely to be rewarded for the taking an aggressively risky position now. After all, it may not be wise going to a party only to find people leaving.

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19 March 2013

is the wall street party ending soon? -...

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