Tayloring a Pantomime Bear

As TMM noted yesterday, a new month brings new appetite to shoot for one's favourite trades, and given that most folks still view the past week's bounce as primarily the result of month-end re-balancing (whether flattered by expectations of Fed easing or otherwise), the default response is to "sell". The TMM IB sentiment meter is still firmly entrenched in bear-mode, with not even a reasonable ISM print able to turn things around, with many using the spike as an opportunity to sell against the 50% Retracement level of the SPX move down from late-July to mid-August. Indeed, this morning, there is no shortage of emails in TMM's inboxes expressing the view that "even if payrolls do surprise to the upside, risk won't be able to rally" and the sheer glee with which punters IB-blasted "*DJ Troika Suspends Greece Inspection Visit" accompanied by bellicose statements relating to the fact that Greece is a mess, and the periphery is a mess, but carefully ignoring to report the later *GREEK EU-IMF REVIEW `NOT SUSPENDED', GREEK OFFICIAL. TMM once again ask "But is that REALLY 'new' news?". Of course not: the European situation is, at best, a muddle through and it is hard to credibly argue that anyone was expecting anything but negative news-flow to emanate from the region. TMM are nonplussed.

Back to the ISM data. TMM have learned over the years that punters never let the facts get in the way of a "great" trade, and yesterday was no different, with bears arguing that even though data surprised to the upside, the trend is down and therefore "down we go". The trouble with this view is that ISM does not point to a recession, and even though there has been a sharp bounce in equity markets, they are still pricing a material probability of either recession or a permanently lower-P/E ratio. Now, to the first point, assuming the consensus are correct with respect to next week's Non-Manufacturing ISM print, TMM's survey-based model would imply GDP growing at around a 1.75% annualised rate (see chart below). Not great, and certainly below stall speed but under such a scenario, earnings are certainly not going to be falling. The blended 12m EPS forecast on Bloomberg of $107.88 for the S&P500 implies just under 17% earnings growth, but even if one assumes something more conservative like 9% EPS growth would put the S&P500 at 1313 with the current P/E of 13.17.

To the second point, TMM have more sympathy. The recent volatility in both financial markets and in macroeconomic volatility have certainly lowered the "fair value" for the valuation multiple in recent months. And while P/E models based upon macroeconomic and financial inputs are highly sensitive to the regression period, for the record, TMM's version (see chart below) is pointing to a multiple over the next 6months of around 12.3x, which would put the S&P500 at something like 1285 (using the blended past 6months/forward 6months EPS). And if applied purely to trailing earnings (i.e. - assuming zero earnings growth, something that appears very unlikely given the above growth points) would still only put the index at 1125. Of course, should volatility fall - something that TMM expect given policymaker actions both at national and supranational levels - then this macro model-implied P/E ratio will move higher again. TMM thus find it very hard to argue that the market is anything other than cheap and, at worst, only slightly overvalued.

And now, to a final point. TMM are often greeted with the statement that if the data is bad that means we're going into recession, but if the data is good that means there won't be any QE3. The trouble with this argument is that the actual reality is far more subtle. To see this, think about what a Taylor Rule actually means in qualitative terms: it tells you what the policy rate should be based upon the inflation gap and the output gap. In English, that means "If growth is below trend, then policy should be eased provided inflation allows it". The worrying point, in this respect has been that core CPI has been rising. However, this is likely to peak this month as the low base effect from last year's deflation scare drops out of the calculation. Regardless of overshoots in both directions and base-effects, a simple old-fashioned output gap model (see chart below, brown line) of core-CPI (white line) has been pretty good at getting the broad trend in core inflation right since the mid-1990s. To the first point, the "good" data still implies below-trend growth, and unless the data improves to the point of implying 3% growth, then orthodoxy would imply that monetary policy should be loosened to offset the widening of the output gap. Simply put, unless the data is *very* strong, QE3 is coming.

And with that, TMM wish their US cousins an enjoyable weekend but not before leaving you with TMM's analysis of the NFP numbers later today.

P.S. - And finally, TMM must extend their heartfelt sympathies and best wishes for a speedy recovery to MacroMan who, we have just been informed, has blown apart his Anterior Cruciate Ligament in his OTHER knee.