The Monday Edition: Market Valuation- Bonds & The Conundrum- Vietnamese Economics

By Yaser Anwar, CSC of Equity Investment Ideas

Market Valuation- The Devils In The Details

• The forward PE of S&P 500 is less than 20, at its previous peak in March 2000, the forward PE of S&P 500 was about 26. Historically, low PEs on large cap stocks have tended to be followed by positive returns over the next 12 months.
• If you take a look at the chart below, notice that the largest 25 companies by market cap in the S&P 500 are trading near 20 year relative lows, thus restraining overall market valuation since these 25 companies account for approximately 35% of the entire S&P 500’s market capitalization.

  

• Earnings of S&P 500 increased at a 19% annual rate in the 3rd Q. What is most remarkable is that this acceleration occurred even as revenue & profit growth was slowing. According to Thomson Financial (source: NYT), S&P 500 earnings are expected to expand 9.6% in the 4th Q. That would be a major slowdown from the 3rd Q & 2nd Q (when profits rose 16.3%)
• In this late stage of the business cycle, the occurring divergence between earnings (going up), revenue & profits (slowing down) growth is surprising because it is hard for companies to contain costs (such as unit labor/ULC). One catalyst could be- Aggressive share buybacks which are boosting EPS, because otherwise its hard to match the sharp rise in ULC with the improvement in earnings as revenue growth has slowed.
• Both core inflation and employment trends should turn decidedly softer in the new year, sparking a turn in policy by both the Fed and the Bank of Canada. Cyclical industries are already seeing the jobs hit and it’s typical for the turn in core inflation to lag behind the start of slower economic growth.

Bond Strategy- Time for a US yield curve steepner or flattener? A conundrum

• Historically, there is a strong correlation between corporate earnings & the spread between 10 year Treasury yields & the federal funds rate. Whenever 10-year Treasuries are yielding less than the federal funds rate corporate earnings tend to slow or go negative.
• Usually when the disparity between these rates is unusually large, some investors say something has to give — either the Fed will begin cutting short-term rates in response to a weakening economy and low inflation, or the economy will start showing its strength & yields will turn higher.
• The conundrum- Is it time to put on a yield curve steepner or flattener (Long US 2 year notes, short US 30 year bonds for steepner & inverse for flattener)? The market expects Fed to lower rates, which would lead the yield curve inversion to normalize. But if you believe the stock market is a better leading indicator then you’re probably going to put on a yield curve flattener with the rational that the bonds will sell off.

A conundrum indeed

Global Macro- Vietnamese Economics

• Vietnam’s economic reforms have being paying off. Since the 90s Vietnam’s exports have increased faster than China’s. Vietnam is the world’s largest exporter of pepper and aims soon to overtake Thailand in rice. It is even selling tea to India and has an annual growth of approximately 25%.
• Recently FDI is flowing into Vietnam. The latest one- Intel is setting up a $300 million test & assembly plant. According to an Intel rep- "Very easy and open negotiation process. They had the right availability of workers, ease of getting permits, and competitive cost structure." Even MSFT is there, I’m not sure of their exact investment though (sorry).
• Like any EM, Vietnam has its cons too. Its infrastructure is not as good as China or India’s and is ranked as the second most corrupt country.
• That being said, the government is working to eliminate corruption and increasingly trying to facilitate FDI. Expect good things from Vietnam.

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