This note was originally published
at 8am on May 24, 2011.
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“There are not enough Indians in the world to beat the 7th Cavalry.”
-George Armstrong Custer
I’m in the middle reading Nathaniel Philbrick’s book, “The Last Stand”, which is an account of General George Custer’s infamous defeat at the Battle of the Little Bighorn. Even a novice in American history knows the outcome of June 25th, 1876, a day in which the 7th Cavalry Regiment was soundly defeated by the combined forces of the Lakota, Northern Cheyenne, and Araphao people on the Montana plains.
In total, according to archeologist reports, the 7th Cavalry suffered a 52% casualty rate. The five companies that were directly under the control of General Custer fared much worse. Near the end of the battle, Custer, and the troops directly under his control, found themselves in a weak strategic position on a hilltop, which would become known as Last Stand Hill. According to almost all accounts, the Lakota completely annihilated 100% of Custer’s troops within an hour of initial engagement.
Ironically, despite the inauspicious ending to his military career, George Armstrong Custer was probably one of America’s most celebrated cavalry commanders of his era. While he finished last in his class at West Point, Custer had a meteoric rise in the Union army and at the age of 23, three days prior to the Battle of Gettysburg, was promoted to Brigadier General.
At Gettysburg, Custer was credited with leading a mounted charge of the 1st Michigan Cavalry. This charge halted the Confederate momentum at the Battle of Gettysburg, which would become known as the turning point of the entire Civil War. Not only was Custer present at General Robert Lee’s surrender at Appomattox Court House, but the table on which the surrender was signed was given to Custer as a gift for his wife with a note from General Sherdian praising Custer’s bravery and his key role in the Union victory.
Perhaps, though, some of Custer’s early successes gave him some false confidence as it related to future military engagements. According to reports from The Battle of the Little Bighorn, General Custer reportedly said the following shortly before his death:
“Hurrah boys, we’ve got them! We’ll finish them up and then go home to our station.”
With the history lesson complete, reading the story of Custer and the Battle of the Little Bighorn made me think contextually about the stock market. In essence, I can’t help but wonder after a +95% move in the SP500 from the lows of March 2009, whether this is The Last Stand of the Equity Bulls. Certainly, both price action and recent data suggests we are at a critical juncture. As well, and not dissimilar to Custer, there is likely an over confidence bias pervading the stock market due to the expedited two year move off the bottom. (LinkedIn anyone?)
Just like the cavalry, we’ve been sounding the warning trumpets of our key 2011 investment theme that Accelerating Inflation will lead to Slowing Growth. No doubt, we’ve been early sounding the trumpet, but the view is now playing out in spades.
A key tell for this theme has been the price of copper, which is down just over -10% on the year. Dr. Copper is perhaps one of the most predictive markets for gauging future economic growth, especially from China, a nation that consumers 40% of the world’s copper. In the most recent data from China, refined copper imports into China were down in April by -48% year-over-year and -17% sequentially from March. On the LME, copper inventories are up +34% from their December 2010 lows.
In other industrial metals, similar trends are in place. Lead inventories are up +53% this year to the highest level since February 1995, aluminum stocks are at near record highs and up +11% for the year, and zinc inventories are up +21% in 2011 and reached a 16-year high on May 18th. Other commodities are signaling the same via price action with lumber down -28% in price in the year-to-date, rubber down -7%, and coal down -6%. In aggregate, the commodity complex is clearly telling us that global growth is slowing.
While the most recent quarter of corporate earnings in the United States was decent, results, broadly, were characterized by margin compression. This was a call our Retail team, led by Sector Head Brian McGough, was early and right in calling. The bell weather indicator of cost inflation this quarter was Gap Stores, who cut their full year earnings estimates from a range of $1.88 to $1.93 per share, to a range of $1.40 to $1.50 per share due to “heavy cost pressure”. Collectively, the “cost issue” was reflected in the number of quarters that “beat” earnings this quarter. Incidentally, beats were down to the lowest level since Q4 2008 at 59.5%.
With a couple more quarters of FIFO accounting and tough commodity input compares ahead for the stock market, the valuation / earnings growth story becomes less compelling for equities, especially in the context of a slowing top line. Globally, slowing growth is being driven by the emerging world fighting inflation, with the most recent evidence being Chinese PMI coming in at a 10-month low. In Europe, slowing growth is and will continue to come from massive austerity measures that are being implemented to, hopefully, head off massive debt restructuring. While in the U.S., the consumer is facing a serious retrenching with U.S. average weekly earnings on a negative trend, unemployment numbers breaking out to the upside, and home prices continuing to be in free fall.
Despite the likelihood that corporate margins continue to compress in the coming quarters, which will continue the trends of slowing earnings momentum, those bullish of U.S. equities argue that yields on fixed income are so low that equities still offer a compelling risk / reward. On some level we agree, as we’ve already made the case for the Fed to remain Indefinitely Dovish and James Bullard, the President of the St. Louis Fed, signaled as much when he said in a speech last night, “past behavior of the FOMC indicates that the Committee sometimes puts policy on hold.”
Being on hold is of course one thing, but not extending Quantitative Easing is quite another. It is the later point that we believe the The Last Stand of the Equity Bulls is predicated upon. Unfortunately, given the fact that reported inflation in the U.S. is actually set to accelerate, it seems unlikely that the Fed will re-up on Quantitative Easing in the short term.
Hurrah, equity bulls! Hurrah!
Keep your head up and stick on the ice,
Daryl G. Jones