Tuesday, May 17, 2011

Citi Equity Strategy

Crosscurrents dominate a trendless market. Investors find themselves dealing with margin pressures, the end of QE, a controversial US debt ceiling, European sovereign credit woes, monetary policy tightening in developing regions, geopolitical tumult and commodity price swings. Yet, corporate balance sheets are flush, employment and capital spending have begun to bounce back as lendingstandards ease, valuation is perceived to be reasonable while acquisitions, stockbuybacks and dividend hikes have picked up. Rising stock markets also haverestored consumer wealth damaged by the “Great Recession” generatingpurchasing power in spite of gas price increases.

The path of least resistance may be to the downside near term. With traditional summer seasonality and some significant uncertainties, especially the US deficit and spending plans plus their impact on long-term discount rates for  asset valuation purposes, it does not appear likely that equity markets can bounce higher this summer unless a truly remarkable agreement emanates from Washington on fiscal responsibility. Moreover, economic data tends to ease back in the second half which probably weighs on the mindset of investors

Valuation is unlikely to move higher or plunge until several issues are resolved. P/E multiples already have slipped in anticipation of margin woes and the lack of perceived inflation based on TIPS breakeven analysis does not imply a sharp de-rating of the P/E ratio. However, the size of government currently and the long-term spending trajectory also limits the possibility of multiple expansion. Hence, investors may need to reset expectations and recognize that earnings are the more crucial factor to track rather than assessing a desired P/E to determine index outcomes.

Sentiment is not sending much of a signal beyond complacency. Various metrics argue that investors are not excessively enthusiastic about stocks to suggest a major downturn is likely and similarly there are few panicked investors to argue that a major rally is imminent either. Some degree of complacency exists as the risks are well known and considered to be “priced in” with portfolio cash positions near the lows experienced in April 2010.

Large cap dividend yielders may provide a safe haven versus so-called defensive sectors. Traditional defensive sectors such as Health Care look to be stretched on different measures and we cannot advocate chasing them, while large cap stocks look attractive on a relative basis and dividend yields might provide some price support when investors are still seeking income given depressed fixed income yields. Additionally, pension funds may need to shift some assets to equities to generate 8% returns since higher quality bonds will not provide better than 4% returns currently. 

No position at this time. Position declarations are believed to be accurate at time of writing but may change at any time and without notice.

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