G3 Recap 2-24-11

Main Items:

  • US Initial Jobless Claims declined to 391k last week vs 405k expected and 410k previously
  • US Capital Goods Orders Nondef Ex Air declined -6.9% in Jan vs -1.0% expected and 1.4% previously, although again the weather probably had an impact.
  • Chicago Fed national Activity Index declined to -0.16 in Jan vs 0.09 expected and 0.03 previously.

Overseas Data:

  • EU Economic Confidence improved to 107.8 in Feb vs 106.8 expected and 106.5 previously

Commentary:

  • There will be no recap tomorrow.
  • Many well respected participants have opined on the cheapness of large caps vs small caps. Certainly, on a trailing earnings yield basis, the differential is near multi-decade highs:

    There are many reasons for this – but the primary reason, IMO, is the availability of money, where availability is defined as yield + availability. With the growth in the US shadow banking system, this is hard to measure, but the yield curve provides a rough sort of approximation. As you can see below, the 2s10s treasury curve has done a good job historically of leading the Russell / S&P ratio:

    But something interesting happened over the last cycle. The differential never really corrected after the curve flattening and the subsequent recession. A potential explanation for that is that financing for PE funds never really went away, given that generally money is committed with very long lockup periods. If this is correct, then assumptions that the valuation differential between small and large cap stocks will correct over the next couple years look unlikely to pan out. In fact, given the relationship above and given where we are in the cycle, we may see it widen even further.

  • Wheat has been under pressure over the past few days, and there have been some media discussions of a top across the agriculture complex. I just wanted to note a few things:
    1) The fundamentals for Wheat were never as good as it was for corn or soybeans. Unlike the latter two, global wheat stockpiles are actually quite high.
    2) As wheat is harvested earlier in the US, wheat has historically lead on the way down. The price action in 2008 is an example:

    3) HOWEVER, given the price ratios, we can expect substitution to be taking place very quickly. (This has already been reported) As a result, substantial increases in the price of corn or soybeans are likely to require a worsening of the supply situation across the entire agriculture complex. In fact, unless this does occur, and if history is a guide, an overall top for the entire complex is likely coming, if it hasn’t occurred already.

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3 thoughts on “G3 Recap 2-24-11

  1. Great blog, I appreciate you taking the time to share your thoughts here. I agree with your reasoning on the large cap vs. small cap situation.

    As far as agriculture, substitution to what? The price of everything has risen, except for rice. There are not many more acres that can be torn up to plant more corn and soybeans (mostly would be hay or marginal CRP land) in the US. It looks like corn may gain some at the expense of soybeans and cotton at the expense of rice, but otherwise there is not much additional flex production available.

    I believe that there is a secular tailwind for agriculture in the form of continued monetary expansion and demand growth in emerging nations. Weather is the x factor and is skewed towards the upside. Ethanol is an additional element that adds some unpredictability, but my thoughts are that politicians are generally supportive of high grain prices as it helps the trade balance and rural incomes, while creating additional inflationary pressures on China that could encourage revaluation.

  2. That being said, as an agriculture bull I’ll admit that alarm bells went flashing in my head when I saw the food crisis cover for Businessweek.

    1. Hi Brain –
      Thanks for visiting and taking the time to comment.
      You’re right on all your points – the only problem is that it doesn’t tell us when the price has increased enough to discount them.
      Furthermore, I would argue that since the supply response for ags is much more elastic relative to say metals, the corrective move can be much greater.
      So I’m a bit paranoid – unnecessarily so far, but it’s definitely keeping me out of bets in Ags > 6 months out.

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