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VOL. 127 | NO. 61 | Wednesday, March 28, 2012

David Waddell

Economy Equal Parts Doubt, Enthusiasm

By David Waddell

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Chimerican Direction Markets fell back from multi-year highs last week as the recovery in expectations since August of last year may have finally eclipsed reality. While the global economic statistics show pockets of strength, they also show pockets of weakness. Add to that shifting balance the unforeseen Iran premium in the price of oil, and the recent bias favors preservation rather than accumulation.

These cycles represent the natural course of doubt and enthusiasm as markets climb the wall of worry. Reality now must lead us forward. With high corporate profit margins, earnings advancement requires revenue advancement. Revenue advancement requires economic advancement. The leading economies of the United States and China receive the highest weight in the analysis. The altitude sickness felt within the market last week stems from concern over China’s economic condition. Diminished manufacturing activity and lower political growth emphasis have challenged the broad market assumption of perpetual Chinese hyper-growth.

Unfortunately, with the Chinese economy complicated and opaque and with government central planning, analysis amounts to gut feel. The greatest amount of reliable insight we receive into the Chinese economic condition comes from corporate comments during earnings season. To that degree, the Chinese economic diagnosis will accumulate in earnest once earnings season begins in a few weeks. While the market awaits further context, U.S. economic data will offer support, while Chinese economic anxiety will offer resistance.

Convergence before Divergence Growth in global trade dwarfs global economic growth, meaning national economies become increasingly intertwined. The economic upside is that specialization unlocks greater prosperity. The political upside is that interdependence and shared prosperity reduce the incentive for conflict.

Nonetheless, as a consequence it’s becoming harder to find insulated economies to diversify portfolios. I suppose North Korea and Cuba might attain “go it alone” status but I wouldn’t recommend them. A look at MSCI Database regional returns demonstrates my point. Year to date, North America, the European Union and the Asia Pacific region have returned 10.5, 10.1, and 10.4 percent respectively. Rarely have I seen such tight geographic correlations.

To explain the phenomena we must remember that while we have traveled a great distance with respect to returns, we have traveled a short distance with respect to time. Earnings and economics need time to reveal themselves, while recoveries in market sentiment can happen quickly. The 2012 advance marks a broad global recovery in investor attitude, which has manifested in two ticks higher in P/E ratios worldwide.

The MSCI World forward annual P/E has moved from 10x to 12x, reflecting a 20 percent improvement in sentiment translating into a 20 percent improvement in returns. But after such a robust sentiment recovery rally, investors may require more proof and more information to calibrate price levels. This exercise will likely result in growing divergences among winners and losers.

So far in 2012, we are all winners. As the calendar matures, so will the rally. Look for selection to begin to override simple participation. It doesn’t necessarily get worse from here, but it likely gets harder.

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