VOL. 127 | NO. 139 | Wednesday, July 18, 2012
The Worldly Investor
Returns Equal Reality Minus Expectations
By David Waddell
At the beginning of the year, expectations ran high. Some economists forecasted U.S. GDP growth rates above 4 percent, European credit spreads indicated crisis containment, and China’s economy appeared to be on a government-conceived glide to slower, non-inflationary growth. As expectations ran high, the first quarter provided stock market investors with the best index returns in 14 years.
The Citigroup Economic Surprise Index helps track economic expectations. When economic reports flow in better than expected, estimates increase. This pattern continues until economists elevate estimates above pending reality. Economists then become negatively surprised until they lower estimates below pending reality. As we completed 2011, economists’ estimates rose rapidly, stoking optimism for the coming year. As 2012 reports started rolling in, negative surprises amassed. As scripted, this litany of worse-than-expected data led to lowered economic expectations. By the end of June, the Citigroup Economic Surprise Index was revisiting crisis-era lows. Today, with collapse of the Eurozone widely anticipated, worldwide recession fears rising quickly and corporate earnings estimates falling briskly, expectations have tanked. With expectations this low, a fate less than death might prompt investment gains … the source of Friday’s rally!
The Big Red Data
What if the assumed automatic high growth rate for China proved false? This second guessing has terrified prognosticators recently. Increased fears of Chinese deceleration met with a slew of national releases last week. The Chinese economy grew by 7.6 percent in the second quarter. While below the double-digit growth rates of yore, the composition of the growth showed quality improvement. The Chinese economy has relied heavily on exports and state-sponsored investment spending to facilitate massive urbanization. Over the last two years, however, wages have increased significantly, feeding into the consumption data. Consumption gains have powered 58 percent of China’s economic growth in 2012 versus 48 percent a year ago. China may not produce double-digit export driven growth rates anymore, but a 7-8 percent self-reliant growth rate from the world’s second largest economy actually provides more reliable upward lift for the world economy. Reality is greater than expectations.
Q2 Earnings Season: Eyes Covered
Coming into earnings season, only 30 percent of analyst earnings revisions have been positive. This number has only been smaller twice in the last decade, both during recessions. Earnings season doesn’t really begin until next week, but JP Morgan and Wells Fargo’s reports offer comforting signals. Trading gains and losses aside, their core banking businesses improved in the quarter. The improvement in housing, while subtle, radiates throughout the economy. Reality is greater than expectations.
In the calculus of investment forecasting, the highest achievement is recognizing that the disparity between expectations and reality matters far more than the reality itself. As an economist, I am not enthusiastic about the current global condition. Nevertheless, corporate CEOs have excelled at making the most of the economic hands they are dealt. With expectations equally depressed for the economy and for earnings, the opportunity for reality to upwardly surprise presents itself … EVEN if that reality itself is simply less depressing.
David Waddell, who is regularly featured in the Wall Street Journal, USA Today and Forbes, as well as on Fox Business News and CNBC, is president and CEO of Memphis-based Waddell & Associates.