This note was originally published
at 8am on October 13, 2011.
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"The credit belongs to the man who is actually in the arena, whose face is marred by dust and sweat and blood, who strives valiantly, who errs and comes up short again and again, because there is no effort without error or shortcoming …”
I’ll admit that my peak athletic days are behind me. At my best, I was a middling college hockey defenseman with a propensity for extended stays in the penalty box. My worst probably came last night in a beer league hockey game in Hamden, CT. Nonetheless, my hometown of Bassano, Alberta has invited me back to speak at the annual Sportsmen of the Year Dinner, so my athleticism is, apparently, still appreciated somewhere.
In a shift of athletic gears, this summer I joined the New Haven Lawn Club and officially began my tennis career. Certainly I’ve played tennis before, but not on clay courts attired completely in whites. As many of you know, tennis clubs are typically populated by people that have spent a good chunk of their lives, well, populating tennis clubs. Needless to say, this Alberta farm boy was a little overmatched this summer. In fact, my summer was spent failing and, often, miserably so.
Personally, I’ve never believed failure to be a bad thing. Now sure, losing or failing doesn’t give you the warm fuzzies inside, but failing and adapting ultimately sets you up for greater success. In a 2008 commencement address to Harvard, author J.K. Rowling, who made a billion dollars for her Harry Potter series, adroitly summed up the benefits of failing when she said:
“So why do I talk about the benefits of failure? Simply because failure meant a stripping away of the inessential. I stopped pretending to myself that I was anything other than what I was, and began to direct all my energy into finishing the only work that mattered to me.”
As it relates to Europe sovereign debt, the one solution that has not been seriously considered is failure. Instead, the key solution from almost every Eurocrat and talking head, is to continue to support and promote a broken banking system and failed monetary union. There are other possibilities: let Greece fail, let other sovereigns fail if they can’t get their house in order, and let heavily exposed banks fail.
The validation of the failure strategy at least partially comes in comparing the credit default swaps of Italy, Portugal and Ireland from July 1st, 2011 to today. Respectively, Italian swaps are up 140%, Portuguese up 38.2%, and Irish down -3.2%. Now to be fair, Ireland hasn’t failed, but three of largest banks, Allied Irish, Irish Life & Permanent, and Bank of Ireland have experienced “credit events” and, as a result, Ireland’s credit worthiness has improved, on the margin.
A more pressing question facing stock market operators is: will this current stock market rally fail? In the near term, the key driver of the stock market will likely be corporate earnings reports. To sustain positive price momentum, companies will need to both hit their estimates and also maintain future guidance. Currently, according to Bloomberg consensus estimates, 2012 consensus expectations for EPS for the SP500 is $106.15, which implies 16% year-over-year growth in earnings.
Certainly, that type of earnings growth is possible for the SP500, but it is highly contingent on underlying economic growth. Currently, our view is the economic growth will be in the sub-1.0% range in 2012. In the last thirty years, there have been five years of 1%, or less, GDP growth in the U.S. On average, in those years, SP500 earnings declined -18.3% y-o-y. Thus, unless economic activity accelerates in the U.S., it is highly unlikely that 16% y-o-y growth in earnings is met. Assuming the Hedgeye view of economic growth is correct, there is substantial downside to current 2012 consensus earnings estimates. History would suggest, as outlined above, that 2012 earnings could be too high by at least one-third.
Alongside earnings growth, there is of course the quality of earnings. J.P. Morgan kicked off the earnings debate this morning with an EPS number of $1.02 that, at first blush, seems solidly above consensus of $0.92. The questions as always, though, relates to the quality of earnings, and $0.29 of EPS was a “benefit from debit valuation adjustment (“DVA”) gains in the Investment Bank, resulting from widening of the Firm’s credit spreads.” So, if we back out the benefit to JPM’s earnings from widening of their credit spreads, EPS declined -27% year-over-year. Yikes !
The more pressing failure in global macro land this morning is the failure of the Chinese to maintain high exports to Europe. To be fair, in aggregate Chinese exports overall were up 17.1% in September, which is a formidable number. Unfortunately, exports to Europe, Chinese largest trading partner, declined substantially, sequentially from 22% year-over-year in August to 9.8% in September. As the Chart of the Day below shows, this is the second slowest year-over-year growth rate of Chinese exports to Europe in 18+ months.
Chinese economic activity is clearly slowing, but in our purview it is still too early to call for massive Chinese easing. As my colleague Darius Dale wrote yesterday:
“All things considered, it could be a while before China pulls the trigger on the monetary easing front. Merely using 2008 as a semi-comparable reference, we saw that China waited a full six months for confirmation of flat-to-down sequential CPI growth and a -380bps reduction in YoY CPI before cutting interest rates in early September of that year.”
Certainly though, growth doesn’t slow forever and whether by monetary stimulus or organic means, the positive catalyst we will be looking for is growth accelerating, on the margin. So far though, it is too early to bet on that.
Keep your head up and stick on the ice,
Daryl G. Jones
Director of Research