What lead from a loss of sector leadership?

By Mike Lenhoff 12:49 27- Oct -2009

When in doubt, take a lead from the markets - even if they’re leaderless, as they are at present. I’ll return to this.

A view I have held is that the primary or underlying trend of equity markets that has been in place since March of this year would not be broken until the Fed signals a change in policy - the assumption being the recovery would not lose steam and nor would the economy relapse into recession. The Fed has been saying no such change in policy is likely for an extended period. So, aside from fretting over the occasional bout of profit-taking, why lose sleep over the markets?  

With Asia Pacific leading the upswing in the cycle, a more recent thought has focused on the regional economy’s lead in ‘exit’ strategies. Australia has raised interest rates already. Now the Reserve Bank of India has announced with immediate effect an end to several facilities providing special liquidity support. Also, the word from the Bank of Korea for a while has been that policy is likely to change sooner rather than later, a message likely to be reinforced by the stronger than expected figure for third quarter GDP growth. To top it off, with the rapid pick up in the momentum behind the Chinese economy, the stage is being set for a change in policy by the People’s Bank of China too.

The authorities in China are not prepared to take chances with their 8 percent target for GDP growth this year and are indicating their intention to stay the course of fiscal stimulus and easy monetary policy, including in this the renminbi’s peg to the dollar. Yet, the fact is that, in contrast to the developed world, a robust recovery is under way in the Asia Pacific economy. In a recent note we suggested that a change in policy by the PBoC could come early next year, thus preceding any change at the Fed, and could induce a strong reaction in equity markets as investors focus on its likelihood (Better to travel than arrive 22 October 2009).

However, this is some while ahead and for now policy makers in the two big drivers of economic growth in the western and eastern hemispheres are telling us of their commitment to reflate their respective economies, so why look for something to worry about? I’m not for spoiling a party but there are at least two reasons for the caution I expressed in my ‘better to travel’ note. First, there has been a loss of momentum in what has been a clearly defined sector leadership in equity markets since their March low. Second, sentiment, as reflected in analysts’ earnings estimates, is as good as it gets, or nearly so.  

On the first point, among the bigger sectors, the financials have led the way. The chart on the preceding page shows that the leadership stalled from about mid-May to mid-July but then equity markets also stalled. The difference this time round is that equity markets didn’t stall. The loss of leadership since early August by the financials happened as equity markets rallied to new highs for the year.

On its own a loss of leadership need not be a big deal. Equity markets could simply be in a transition phase attempting to establish a new leadership and, among the larger sectors, mining and oil & gas may be it. These sectors benefit from a weak dollar. They are also major beneficiaries of the cyclical upswing led by emerging Asia and moreover, if the Chinese authorities are, like the Fed, telling markets they intend to persevere with existing policies, this helps them too. On the other hand a loss of leadership could mean that equity markets are tiring, that they are up with events and ready for some profit-taking, which is where I think we could be at.

The second point is illustrated in the chart below which traces the earnings revisions ratio for the S&P 500. The US series is the longest available for the major indices. The ratio measures the analysts’ upgrades as a proportion of all estimates upgraded and downgraded. As the chart shows, the ratio is approaching the peak reached during the recovery stage of the last upswing in the cycle and is already above the peaks of previous cycles. It reflects the fact that sentiment on the prospects for earnings is running high - indeed, almost as high as it gets. 

The sentiment is understandable. Thus far in the US results season, for every company that has disappointed with its earnings, 6 have surprised on the upside. But not only that, the bottom line that companies are delivering is no longer just the product of cost cutting and restructuring but also the result of a marginally better than expected top line reflecting the economic recovery that is beginning to come though in the US and elsewhere.

So why, when things are looking up, the loss of sector leadership? I feel equity markets are just running out of puff after having discounted the best of the recovery news. As the top chart on the next page shows, equity markets have reclaimed their pre-credit crunch ratings. The 12-month forward p/e ratio for the FTSE All-World Index is back to where it was at the time of the initial sub-prime sell-off in July 2007. There are no two ways about it; the re-rating has been astonishingly rapid.  

If we are heading into a bout of selling I would expect any move into defensives or Treasuries from a flight to quality or safety to start pushing up the dollar. As the lower of the two charts on the next page shows, the rebound in global equity markets from their March lows coincided with a turn in the dollar. Perhaps investors have gone too far in pushing down their boundaries of risk aversion. It may be that the time has come to retreat a little. A recovery in the dollar will be a good indicator of where equity markets or risk assets generally are going.