Recap 1-10-12

Main Items:

  • Fitch says it does not expect to cut France’s AAA rating this year, but Italy or Spain could be downgraded 1 or 2 notches. “unless there is a material deterioration in the Euro Zone.”
  • US Small Business Optimism increased to 93.8 in Dec as exp vs 92 prev.


  • UK RICS House Price Balance improved to -16% in Dec vs -19% exp and -17% prev
  • China Trade balance increased to 16.5bn USD in Dec vs 8.8bn exp and 14.5bn prev. Import growth dropped sharply to 11.8% YoY vs 18% exp and 22.1% prev. Export growth was inline and stable.


Another reason I haven’t been bullish risk despite the better data is the fact that US taxes are likely to jump substantially in 2013. First, the 2% social security tax cut will be reversed. Second, high income individuals will pay another 0.9% in Medicare taxes. Third, there is a 3.8% Medicare tax for high-income households on investment income starting in 2013. And finally, given broad support for deficit reduction, additional measures are likely to take effect in 2013, given that US presidents like to pass growth-reducing legislation early in their time in office. Given that US growth has averaged just 2% over the past several quarters, unless US consumers build up their savings ahead of this series of tax hikes, it’s hard to see how US growth can power through this. At some point in the next 3-6 months, US equities should begin to price in this risk. These risks in 2013 may be an additional reason Treasury yields remain near their lows despite the improvement in coincident data as well as equities.

An additional warning light is the fact that S&P margins may be close to be peaking. Aggregate profit margins are now just 50bps below the 2007 highs, which were achieved when financial companies were rapidly increasing leverage. Historically, downturns in profit margins have coincided with declines in corrections or bear markets.

I acknowledge that despite these looming clouds, given recent data trends, it is too early for a bearish position. As a result, I am content to be neutral for now, looking to express macro views on a relative basis where possible.

Note that the argument that equity P/E ratios are cheap does not really apply. (I have been guilty of doing this myself) The general claim is that P/E’s are cheap versus a multi-decade average. But using a multi-decade average as a benchmark for a volatile indicator to make asset allocation decisions one year forward does not make sense. Furthermore, if the correlation between demographics and P/E ratios holds, P/E ratios are likely to compress over the next decade. The current P/E ratio of 13.6 looks fair, not cheap. If P/E projections hold, the 38% decline in P/E through 2025 will necessitate a 60% increase in earnings over the next 13 years, to maintain current price levels. This equates to an earnings CAGR of 3.8%.

The demographics setup since 2000 is similar to the demographics starting in the late 1960’s. Here is a (cherry picked) analog chart of the S&P of those 2 periods. Note also that the demographics over the next decade will be worse for growth than those prevailing in the late 70’s, and will stay worse for longer.


2 thoughts on “Recap 1-10-12

  1. With all due respect, it strikes me as a little odd that you are not bullish risk assets based on tax hikes that are to be implemented next year. For whatever reason I thought your investment horizons were shorter than that.

    The reason I am a little reluctant to buy into the stronger US growth story is that it is coming on the back of consumers, who are increasing spending without a parallel increase in incomes. Savings rate is still positive, but plummeting. Clearly unsustainable..

  2. You’re right that my investment horizons are shorter than 1 year. But if I only look at things 6m forward, I think I’d wind up missing a large portion of the picture. I should clarify that I weigh events more than 6m in the future in my decisions in conjunction with shorter term views to formulate a more nuanced view. And you’re certainly right that the low savings rate is an issue. As a result, these tensions w/ Iran make me quite nervous. With the Iranian CB and other entities cut off from its funds, an upcoming election, and all these Israeli attacks, it’s not hard to see them doing something irrational. Brent is just below resistance levels…

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