Commodity Sector on a serious run Baltic Dry Index zooms 5.4% yesterday….

Posted by David Rosenberg - Gluskin Sheff

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CAUTION ON CANADIAN DOLLAR:

Crude oil and the metals have broken out but natural gas and forest products
(together 10% of the export base) have actually fallen during this CAD run.  The
CRB index has gone nuts but the rally in the loonie has more than doubled the
increase in the BoC’s commodity index so this has actually been a significant net
tightening of monetary conditions.  I don’t think the BoC necessarily changes its
outlook but if it doesn’t at least pay any lip service to what the currency has
done since the last meeting I think it is going to look out of touch.  All that has to
happen in the statement is an acknowledgment that the appreciation, while
deserved based on the favorable terms of trade shock, has overshot the
commodity fundamentals nonetheless.

Just a hint that the BoC isn’t happy with the pace of the CAD’s runup, which is
destabilizing for the economy, let alone unwarranted (also unprecedented) —
could well see a few pennies lopped off the loonie if investors decide to take
same profits.  As an aside, the CAD has the identical correlation with natural gas
as it has with the oil price (70%).  I would say that the loonie “should” be trading
closer to 83 cents as opposed to 93 cents based on what the overall terms of
trade effect has been from the commodity price pickup.  So brother, can you
spare a dime?

But make no mistake, the commodity sector is on a serious run here, and looks
like the flip-side of the breakdown in the U.S. dollar, which has declined to its
low water mark of the year and could easily slip another 5-10% from here.  Oil
prices have surged to their highest levels since last November (like so many
other things) and seemingly poised to move into that OPEC range of $70-75/bbl. 
Copper has broken out in a meaningful way too — now at a fresh seven-month
high.  The CRB index is firming too and just came off its best month — a 14%
run-up in May — since July 1974.

The much-maligned Baltic Dry Index surged 5.4% yesterday and has now
doubled in just the last month, and this has proven in the past to be a fairly
decent leading indicator of the broad resource complex.  Unlike the USA, which
has not enjoyed a three-month string of 50+ ISM prints since September-
November of 2007, China just managed to achieve that feat — hence the rally in
the commodity market.

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As we said yesterday, this bodes well for the Canadian stock market, which has
an 86% positive correlation with the CRB index versus 28% for the S&P 500. 
Moreover, while the Canadian economy is clearly hitched to the United States,
the TSX enjoys a 60% correlation to the Shanghai index — whereas the more
insular U.S. market is only 40% correlated.

Plus

 

There are four factors driving the equity markets:

  • technicals
  • fund flows
  • valuation
  • fundamentals

Let’s examine each one at the current time.

1. With regard to the technicals, they are uber-bullish.  Not only has the A-D
line broken out to the high side, but the S&P 500 yesterday broke above
the intra-day high of 943 set back on January 6, not to mention taking out
the 200-day moving average.  The ultimate retest will have to wait
another day.  This market is at risk now of melting up; and, as I said
before when I was keeping an open mind regarding the longevity of this
rally, notwithstanding my skepticism, if credit spreads, Libor, the Ted
spread and commodity prices could all go back to pre-Lehman levels, why
couldn’t the S&P 500 too?  That would mean a possible test to the high
side of 1,200, believe it or not.  That is an observation, not a forecast, by
the way.  Back when we hit that level last fall, it was a glass-half-empty
feeling of being down 20% from the highs; this time around it is a cause
for celebrating an 80% move off the lows!  The S&P 500 is now up more
than 4.0% for the year; the Nasdaq, which was the first of the major
averages to break above the 200-day m.a., is up 16.0% year-to-date. The
Dow is roughly flat.

2. The rally seemed to have stalled out on May 8 and for the next three
weeks, all the market seemed to do was range-trade between 880 and
920 on the S&P 500 … until yesterday.  The initial source of buying power
in March was the dramatic short-covering and pension fund rebalancing. 
Then in April the retail investor became enamoured of the ‘green shoots’
and found $12 billion of money to put into equity mutual funds (only the
second net inflow in the last year, by the way).  And, as May morphed into
June we likely have started to see the capitulation among institutional
portfolio managers, who collectively shard by cautious view.

2. The rally seemed to have stalled out on May 8 and for the next three
weeks, all the market seemed to do was range-trade between 880 and
920 on the S&P 500 … until yesterday.  The initial source of buying power
in March was the dramatic short-covering and pension fund rebalancing. 
Then in April the retail investor became enamoured of the ‘green shoots’
and found $12 billion of money to put into equity mutual funds (only the
second net inflow in the last year, by the way).  And, as May morphed into
June we likely have started to see the capitulation among institutional
portfolio managers, who collectively shard by cautious view.  
As the just-released Barclays survey of some 600 fund managers
revealed, fully 60% had been viewing the move off the March lows as a
bear market rally, less than 5% bought into the V-shaped recovery
forecast; and only 9% were fully invested.  The risk of being pressured to
chase performance is high, and along with that, the odds of a further
melt-up, all the more so with the technicals being pierced in resounding
fashion.

3. The global trailing P/E multiple has surged five points during this rally to
15x.  So this market is far from cheap.  Let’s look at the S&P 500.  A
classic mid-cycle multiple is 15x, so basically the market is pricing in $63
of operating earnings.  That is being generous because based on where
the corporate bond market is trading, the fair-value multiple is around
12.5x, which then means that equities are discounting $75 of earnings,
which we would not expect to see until 2013 at the earliest.  (A 15x
multiple is also rather generous when one considers that we now have an
economy where large chunks — autos, insurance, mortgages, banks — are
at least partially owned by the government.)  Look at this way — we are
going to be hard-pressed to see operating EPS much better than $43 this
year.  A ‘normal’ first-year earnings bounce is 20%, and again this is being
generous, but that would leave us with $52 EPS for 2010.  
We give that prospect very little chance of occurring, and we have some
difficulty with the stock market going ahead and pricing in an earnings
profile that is likely four or more years away from occurring.  Are we going
to be back pricing in end-of-cycle or recession earnings this time next year
at the rate at which investors are discounting the future.  There may be
upside to this market based on factors (i) and (ii) but we remain
concerned about its longevity because at some point, post-bubble
earnings realities in a deflationary top-line environment (nearly two-thirds
of S&P 500 companies missed their revenue targets in Q1) will re-emerge
on the front burner.

4. The economic fundamentals are open for debate, to be sure.  The same
consensus and equity market that couldn’t see the recession coming two
months before it did surface back in 2007 are now supremely convinced
that the recession is over and that economic renewal has begun.  This
has gone even further than ‘green shoots’.  But what provided the real
spark yesterday was the ISM index coming in at 42.8, up from 40.1 in
April; as with the consumer confidence surveys, this was the best result
since last September when Lehman collapsed.  What caused the
excitement was that the folks at the ISM claimed that at 41.2 on the
business diffusion index, the recession comes to an end.