by Brian Pretti CFA, Contrary Investor. January 18, 2008
Makin' The Call
Before getting to "those twins," I want to very quickly point out that it sure as heck appears that the CEO's in this fair land have called a recession. No equivocation and no hemming and hawing. A recession it shall be. You may remember that late last year I penned a discussion entitled, "The CFO Nose," that essentially detailed the relatively short history of the CFO confidence survey. Important message of that report being that these folks were as negative as anything seen over the short four-year history of this survey. The implication, of course, was that the economy was indeed at risk given that the coincidental rhythm of CFO confidence levels over time and annual change in real GDP have been very coincident.
Well if that weren't good enough for you, let's have a quick "listen" to what's being said in yet another corner of the executive suite – the office of the CEO. The CEO confidence survey for 4Q was released on Tuesday of this week. And right to the point, it’s a definitive call for recession by those CEO's responding to the call. As is often the case, pictures can tell meaningful stories. So, have a look at the following story, if you will.
This is the longer-term history of the CEO survey with recessionary periods clearly marked. Notice anything? Of course you do. At least over the last three decades, every single time the level of survey responses has descended to a level we now see, the US economy has been heading into recession. Every single time. There are no exceptions. So, either the CEO's of this world have lost their magic touch and are now out of touch in the current cycle, or a recessionary experience is about to touch the US economy. It's either one of the two. I'll bet with the CEO's until they are proven guilty. In the past this survey has been very important as a warning. But not to dwell on the negative, this survey has also been very helpful in identifying turns back upward in the trajectory of the US economy. In my mind, a recession has arrived. Now it’s a matter of watching depth and duration in terms of CEO's "getting in touch with their feelings." What a sensitive bunch.
I Love Burritos At 4AM, Parties That Never End. And Twins
Are you sure about that? The burritos and the parties, okay. It's the twins you better think about. Every so often on the CI site I throw a little Rorschach test at readers. Now it’s your turn. Have a look.
Certainly it doesn't take a visionary to see the similarity between these two chart patterns. Twins? Kinda' looks that way, doesn't it? Given the almost reflection pool image of the combo chart, have these two investment vehicles been shaped and driven by similar economic fundamentals? Do they reflect a common investment or economic theme? Both appear to be resting on relatively critical technical demarcation lines (as of the close on Tuesday the 15th) in simultaneous fashion. I'd have to say that if these lines are broken simultaneously and sustainably ahead, it will be one very strong statement about both the US economy, and I'd sure as heck guess the financial markets also.
Okay, what are we looking at here? The top portion of the chart is the XLF – the financial sector spider. The bottom portion is the XLY – the consumer discretionary sector ETF. At least to myself, the message here is loud and clear. Discretionary consumer spending stateside has been and continues to be driven by the macro US credit cycle. A credit cycle that has now been checked into the financial intensive care unit, a victim of serious long-term abuse at the hands of the central bank, the non-bank financial sector, and the banking system itself. After all, who needs enemies when you have friends like that, right?
So just why is this important to us as we move into the new year, and how will monitoring this combo chart influence our investment activities? First, as we should all recognize, the financial sector in recent years has become the largest weighting in the S&P 500. The following chart chronicles the history of the financial sector weight as a percentage of the S&P across the decades. In my mind, it simply parallels the growth and meaning of the credit cycle to the very character of US economy over time. The twists and turns memorialize the transformation of the US economy from a relatively large industrial force to a more service (read credit driven) oriented economic fabric.
So as I look at the chart above, I have to ask myself, are we now looking at the very beginnings of perhaps further important change in the character of the US economy again? A change that minimizes the influence of the credit cycle on economic results in the years ahead? Only time will tell. But if so, without sounding melodramatic, that changes everything. I believe it’s something to at least consider in terms of longer term, or secular cycles.
To the here and now, what's also important is that over the decade to date period, the S&P financial sector has not only dominated the capitalization weight of the S&P, it has also been the lead sled dog in terms of weighted nominal dollar earnings by sector. No other sector even comes close to the earnings produced by the financials, except energy in recent years. Of course the very deep write downs and write offs of the moment by these very same financial folks are now "telling" us that a lot of those supposed earnings that were reported were essentially smoke. Quite reassuring vis-à-vis forward investor faith in this sector, no? But as the sector specific earnings hits surely continue for a while for the financials, so does pressure on total S&P earnings. As I look ahead, THE largest near term macro risk I see based on what I believe are overly optimistic forward analyst estimates is disappointments relative to current earnings expectations. The credit cycle damage has been too great for S&P earnings to V bottom in 2008. We're already seeing the damage disappointments are having on equity prices in the early part of this year.
Additionally, what the heaviest sector weighting in the S&P that is the financial sector tells me is what has already been bought. Essentially what is over owned, and that is the financial sector plain and simple. After all, a sector does not achieve top capitalization weighting status by being neglected. Remember tech in 2000? Err… maybe you don't want to (it’s weight in the S&P was ultimately cut in half). So for jolly S&P index fund holders out there who have essentially earned nothing on their investment in eight years now, I'm sorry to suggest that you are about to be hit again as the financial sector weighs on S&P index earnings and price while contraction in the capitalization weight of the financials most surely continues.
Getting back to our little Rorschach test chart, the second reason this combo chart is so important in its simultaneous message as to the shape and character of the US economy is embodied in the final chart you see below.
You didn't need me to show this to you, did you? Yes, personal consumption is vastly important to US GDP. Anything influencing the character of consumption influences the character of the real economy. And what has been a primary influence to the character of consumption for some time now? The credit cycle delivered to us by the US financial sector. And quite necessarily, this has direct implications for our investment choices.
For now, the CEO's are suggesting well ahead of the NBER, Street economists and pundits everywhere, that a US recession will be a reality – whether officially published or not. To be honest, "the twins" are singing the same song. If the twins break their very important technical demarcation lines in simultaneity, they will no longer be singing. They'll be screaming. Personally, I love football, shots of Gina Lee, hanging with my friends, but I'm not too sure I like "those twins." How about you?
© 2008 Brian Pretti