Conclusion: In the three charts below, we highlight key risks to hopeful expectations of a sustained recovery in earnings growth and a tranquil global investing environment over the long-term TAIL. In fact, when analyzed with a wide enough lens, the data suggests that equity market headwinds are significantly less “transient” than is currently anticipated by consensus.
Position: Short US Equities (SPY).
We get called out a lot for coming off as short-term in nature. While there is certainly some merit to that claim (our style of managing risk acutely focuses on timing), we don’t necessarily agree with it in its entirety. In fact, we focus a great deal of our research on the longest of long-term trends (refer to our firm’s Sovereign Debt Dichotomy and Housing Headwinds presentations for key examples of our longer-term work), and, within the context of these bigger picture themes, we manage risk around the Duration Mismatch that’s typically ever-present in the world of investing.
Timing is everything. I believe a famous investor once said:
“It ain’t what you buy, but rather when you buy it that matters.”
To that tune, we think by the end of 2Q11 we will be able to confirm that the peak in corporate earnings for this cycle was actually in 1Q11. Including our own, many charts have been circulated around the street about peak corporate profits, but that hasn’t actually mattered until, well, now. To quickly rehash our out-of-consensus view, we think the stench of Jobless Stagflation starts to show up in the 2Q11 earnings season in the form of sequentially deteriorating corporate earnings growth on a go-forward basis. For more color on this topic, refer to the following reports:
- 5/18/11: “Eye on Earnings: Growth Slows as Inflation Accelerates”
- 5/22/11: “Early Look: The Last Stand of the Equity Bulls”
This stance is strongly supported by the fact that corporate profits are what we’d consider extremely stretched on a historic basis. Using BEA data, we were able to back our way into corporate EBITDA margins on a national level, as well as corporate EBITDA as a share of the overall economy. From a standard deviation perspective, both metrics are currently residing in rarefied air (2.3x and 2x, respectively). From a more quantified stance, 95% of observations fall within 2x standard deviations of the mean; thus, mean reversion in both series is likely over the longer-term. That’s not a bullish data point for long-term investors. It is, however, a “game on” challenge to risk managers. Be it boom/bust, bubble/burst, or expansion/contraction – alpha is always there to be captured.
The final chart we’d like to show you is borrowed from Carmen Reinhart and Kenneth Rogoff’s oft-cited, long-term work on sovereign debt. The illustration lucidly expounds upon a simple concept that we’ve been beating the drum on since late 2009: we are in the early stages of the global sovereign debt default cycle. As the chart repeatedly shows throughout the last 200-plus years, the sovereign debt woes of fiscally imprudent countries like Greece rarely (if ever) get better without first getting a lot worse. Moreover, when the cycle peaks, it’s typically a global phenomenon with 35-50% of countries in some form of default or restructuring.
While global financial markets will more than likely cheer on and celebrate any/all attempts to kick the proverbial “can” down the road, we continue to remind investors of a simple point we began making over 18 months ago: be very afraid of Europe’s periphery – especially if you are a long-term investor.