The Weekly T Report: From QE to PE

Posted by on Jul 28, 2012 in Uncategorized | No Comments

Don’t the Markets NEED QE?

No. While QE has helped support the market and was the main reason the S&P 500 managed to stay above 1,300 in spite of weak data, it isn’t necessary. Taking the most “disruptive” scenarios off the table in Europe is more important. If Europe can stabilize, then the markets could price in a better “multiple”. One thing holding down the PE multiple is the concern that Europe could become a complete disaster. As that get removed, there is the real possibility that investors will get more comfortable with risk and we can see a multiple expansion. If we see over time, some (and I hate the term) “green shoots” in Europe, then we could actually see some increased expectations of earnings. Europe has been a drag on earnings, and pessimism about Europe is keeping earnings forecasts down, but it wouldn’t take much of a turn in Europe to give earnings here a small boost.

So if (and it remains a big if) Europe takes tail risk off the table we could see an increased multiple, and if Europe actually manages to stop the slowdown, then we could see earnings expectations grow, so the market could do well as it shifts from QE to PE.

I think much of that is already priced in. I keep thinking that 1,400 to 1,425 is a top for the S&P 500 in the near term. The U.S. has decoupled so much that there just isn’t that much upside, and as the world turns its attention to our problems, we could well see weakness here.

Banks should be the sector that benefits the most from any fix in Europe. They have been most hurt as an industry over concerns about Europe (separate from Volcker rule concerns and LIBOR scandals). Spanish and Italian companies can benefit the most as they have felt the brunt of the “risk off” trade. While the S&P 500 is up 10% YTD, and the DAX is up 13%, Spain is still down 23% and Italy is down 10%.

Europe Won’t Deliver?

Ugh. I’m not sure that “ugh” is a real answer but is my reaction to that question. I would like to give an unequivocal and resounding NO but history demands some caution. While Europe has failed to deliver on so many occasions, there is real reason to believe this time is different. There are more people who have openly expressed a willingness to do what it takes. The hints of the plan are within existing mandates. The German economy is deteriorating as well, changing their focus. The farce of complaining that Greece isn’t making reforms when most of the money is being used to pay back the ECB has become too obvious. The economies across the entire region are faltering or in depression. Both Draghi and Novotny used the “transmission” expression which seems too specific to believe it was a casual reference and not a rallying point. There are more reasons than that, so I believe they will act, but have taken some risk off the table because they have failed to deliver so often, so betting on success at these current levels makes sense, but I want some room to add if they fail. Monday was the time to be “all-in” today is not.

There is no plan?

Wrong. Details are coming out and it looks like there is a plan. What has leaked so far is a multi-pronged approach that would address many concerns and fits within the existing mandates. Even more importantly, in spite of confusion to the contrary, it works around many of Germany’s concerns. That is important and I expect the Draghi Weidmann meeting to confirm that they can work together. In fact the template we have discussed often and re-iterated yesterday morning seems to be in line with what has been leaked so far.

Even if the plan is implemented, nothing is fixed?

Wrong. The economies in Europe are grinding to a halt at least in part because of the risk and confusion about currency redenomination. Investors are scared of owning Spanish and Italian assets out of fears that they will get converted into some worthless Pesetas or Lire. Even Germany is being affected. Who wants to do business in a country that could see a spike in their currency if they switch back to the Deutschemark. So this plan should take currency redenomination risk off the table for now. That risk cannot be underestimated as it caused bank runs and much of the distortion in negative bond yields.

Taking the conversion risk and imminent default risk off the table is a big step. It eliminates some of the worst scenarios as an investor, and more importantly as a businessman. Companies can spend less time worrying about their existing assets and exposure to the region and spend some time on developing new business strategies.

So Europe is fixed?

No. There is a big difference between nothing being fixed and the whole problem being fixed. This plan, assuming it is implemented (ideally in the way that I outline) then the immediate problems of default and redenomination are taken off the table. That is it. From there we need to see growth.

The private sector will still be reluctant to do much, so the EIB and the “project bonds” will have to be used to spark some growth. The governments will have to use stimulus to stop the decline and give the first sign that things can get better. They need to spark some job growth. Money has to get to companies and they have to see opportunities to make even more money by investing. That won’t happen quickly, but just like the U.S. in 2009, the markets will react positively to any signs of “green shoots” (I really hate that term).

Europe will also have to work towards a more “standardized” approach. Countries will have to move to a normalized tax and benefit system. Spain in particular will need to focus on bringing the underground economy into the measured and taxed economy. There will have to be some painful changes, but these don’t have to happen overnight – nor should they. But they have to happen.

Europe needs to use the breathing room an aggressive ECB program creates to implement these changes and spark some growth.

Is Draghi Dumb?

No. The bear case relied in part on Draghi being so stupid that he couldn’t see the obvious consequences of his inaction. Well, he saw what would happen if he didn’t act and is trying to act, so clearly he isn’t the “deaf dumb blind kid”, though I don’t know if he plays a mean game of pinball or not. I will ask him when I meet him.

Enjoy the weekend as there should be no shortage of headlines to move the market next week.