| As we begin the second half of 2009, it is important to take a look at where we are most likely heading. As we have been saying for the last couple of months, we expect the recession to end once General Motors begins production at its recently closed plants but the end-of-the-recession trade was likely over once the May employment report was announced. The S&P 500 ended 2008 at 903.25, which was 18.24 times trailing earnings. Since World War II, we have yet to see the S&P 500 trade at a lower PE multiple the year a recession ended than it did the previous year. We believe a trailing PE multiple of 19.0 to 21.5 is a reasonable target for the end of 2009 assuming a double-dip recession does not occur in the first-half of 2010, which is also a reasonable possibility. Standard & Poors tells us that the consensus top-down operating earnings estimates for the S&P 500 is $43.03 per share. However, given the recent estimate raises at Morgan Stanley, Bank of America-Merrill Lynch, and others, we believe $50 per share is the true expectation at the moment. The next couple of weeks will say a lot about how reasonable this expectation is and where estimates are likely to move next, but at the moment this suggests a year-end target for the S&P 500 in the 950 to 1,075 range. How the stock market gets from here to there is likely the bigger issue and the topic getting the most attention from nearly every technician recently is the formation of a head and shoulders pattern. This suggests downside risk for the S&P 500 to the 875 support line and a potential break. So, in the short-term, this is the pattern we need to watch most closely heading into second quarter earnings season and it implies we need to look for short opportunities at least to start out the season. From a sector view, most data points have changed little over the past several weeks. Consumer Discretionary stocks continue to manage inventories well with upside risk from a better-than-expected economy. Technology tracks well from both an inventory basis with demand also holding up well. Financials have macro tailwinds with among the most profitable spreads on record and the possibility of inflation increasing the written-down assets on the balance sheets. |  |
The recent surprise has been the Consumer Staples. At the beginning of the year, as the group was preparing their budgets, production was apparently cut too far and production is currently rising to meet demand. Our informal checks suggest the production isnt too the point of hiring back laid off workers, but many production lines are running well above the targets set at the beginning of the year just after the financial crisis started and many workers within this sector are seeing overtime. Meanwhile, material costs are declining, the U.S. Dollar has weakened, and few have lowered the prices that were raised this time last year before Lehman Brothers collapsed.
On the other hand, the inflation trade continues to appear much too early for the cycle and, in fact, continue to see weakening trends with lower demand and rising inventories. The data points for the Industrials, the Materials, and Energy suggest these continue to be the sectors with the most downside risk at the moment and only the weak U.S. Dollar is supporting the stocks.
While we believe the overall risk to the stock market for the year is to the upside and believe the Financials have the most wind at their backs, we are less confident about the group at the beginning of this earnings season than we were last quarter. Weve yet to have a meaningful rally in the overall market without the Financials rallying, so while the S&P 500 is forming a head and shoulders pattern, the Financials are failing to break the trend line set since the markets high in October 2007.
We are more than a week away before the major Financials release earnings, but even though checks are positive for the group if we are going to trade the stocks going into their earnings release in anticipation of an earnings beat, the 875 line needs to hold as support for the S&P 500 and the trend line for the Financials needs to be broken.
The past several weeks since the Presidents decision to give unions priority to assets over debt holders in the General Motors and Chrysler bankruptcies the U.S. Dollar has been the primary focus for the markets. At the moment, we are seeing long-term professional currency traders go long the U.S. Dollar on the view that we are still in the early stage of a multi-year bull market for the Dollar and we have professional macro traders bet on a long-term bear market for the Dollar for political reasons. We are not comfortable assuming either side will win out in the long-term and, therefore, are only short-term Dollar traders and anytime there is Dollar strength, we want to short the Industrials, Materials, and Energy sectors.
At the moment, we see more upside risk to the Dollar. When we watch the Dollar, we focus our attention on the Euro the anti-Dollar and sentiment continues to suggest small traders are extremely bullish the Euro and commercial traders are adding to their short positions. We will always take the side of the commercial traders in this scenario and, to support this view, we have a stochastic cross at a lower-high for the Euro.
On the fundamental side, the Eurozone continues to ease while Australia, Switzerland, New Zealand and other countries have been publicly discussing the damaging impact of the weak U.S. Dollar on their respective economies and have either taken steps to weaken their own currencies or have suggested they plan to cut rates and/or take additional easing steps.
At the same time, we are in a seasonally strong period for the U.S. Dollar as Japanese summer bonuses tend to leave Japan for the U.S. Furthermore, the Chinese cycle suggests there is downside risk to the inflation trade from economic data points and from a U.S. Dollar story. As we have mentioned previously, China tends to see a peak in production during the month of April, restock inventories in May, and, starting in June, begin a period of buying U. S. Treasuries. Perhaps China will divert more capital into its own stimulus plans, but we tend to believe this is more likely priced into the market rather than the possibility that its previous cycle trends will resume and that means upward pressure on the U.S. Dollar and downward pressure on commodities. It is our view that, political issues aside, the relative value of the U.S. Dollar vs. the rest of the globe that is lagging in terms of economic activity as well as central bank easing policies. We also believe that the stock market does not have to depend on Dollar weakness to rally. However, in order to be truly bullish now that the end-of-the-recession trade is over, we believe the sectors that are seeing favorable data points need to outperform those that have rallied simply because of the weak Dollar. This week and early next week, as the initial earnings releases for each sector come in, should provide the basis for trading during the remaining weeks of earnings season.
One recent data point that we have neglected to discuss thoroughly is our Earnings Expectations oscillator shown on the front page of our website and on the first page of this report. Analysts are conservative by nature and when they, as a group, become increasingly optimistic about the possibility of a near-term upside earnings surprise from the companies they follow to the point that more expect an earnings beat than expect an earnings miss, it tends to be a positive indicator for the overall market. We have not had a buy signal since the recession began in late 2007, but data checks have been positive and we have had a handful of buy signals over the past few weeks.
The market could be a sign that there is too much optimism going into earnings seasons and we are setting up form disappointing results, which is where we are leaning, but that is not the signal this indicator has given us in the past. Therefore, we have to view the recent stock market activity as a consolidation ahead of another move to the upside until we are shown otherwise. Consequently, we are giving the 875 support area the benefit of the doubt and will look to be buyers near this level, but will wait for overall price action and earnings news to confirm before we become too aggressive.
Alcoa
There was a tremendous amount of buying of shares of Alcoa (AA) in mid-March and this has created a support base that likely needs to be respected, but the stock is currently a long way from this point on a percentage basis and we have yet to see any positive data points for the company. In fact, all data points suggest production continues to outpace sales so that decade-plus inventory levels continue to climb. To make matters worse, Chinese production of the metal appears to be picking up, which means inventories levels are likely to continue to climb and that is very bearish for the stock in the longer-term.
The stock generally trades at 12.4 times forward estimates, which suggests the stock should be trading closer to $5 than its current $10 range and, unless Alcoa gives evidence that trends are going to change soon, the stock is likely to trade below most of the recent target prices established by the analysts, which are in the $8 to $9 range.
For the quarter, the consensus estimate is a loss of $0.34 per share and the Earnings Whisper number is a loss of $0.40 per share.
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