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Davidson: “The Next Few Months Look Interesting”

From the man who at the end of March emailed me and said “I am all in” ……..what a call.

The recent move away from Developed Country Sovereign Debt was prompted by the recent US$ weakness and I viewed this as most likely part of a momentum driven carry trade. It appears to me that the global recovery is going to continue barring any unpredictable events and that the effect of the carry trade could be short lived.

Should Bernanke indicate that that he is in the process of taking action, I believe you will see a reversal of this momentum activity. The recent NYFed Tri-Party Repo action which the Fed deemed a test of the liquidity reversal process may actually be a warning to the current carry trade that a change in the profitability of short the US$/long oil, gold, copper and equities could be short lived.

It may cause the market to pause as the carry trade provides HFs with substantial access to liquidity that they cannot get currently from their historic sources, banks and investors. Seeing the market pause even with earnings in excess of market forecasts along with a strong 3Q GDP would not surprise me.

However, I would expect the markets to continue their improvements as there yet remains up to an estimated $4Tril of former risk capital still residing in Treasuries across maturities. I think with inflation at the moment low and (I hope) Bernanke’s skillful approach to keep inflation tame that there remains substantial potential in equities of all asset classes. Inflation is the key as it strongly impacts market P/E’s inversely. Inflation at this point is one of my primary focal points and at the moment it is falling which is good. Lower inflation permits higher P/E’s and vice versa.

A helpful way to view the potential liquidity which could enter the SP500 is to have an estimate of fair pricing. I use a derived Market Capitalization Rate which is currently 4.76% and then capitalize the historic earnings trend at 115%. The historic earnings trend for 70yrs places SP500 earnings at $64.50 as of 3Q09.

Doing the math: $64.50/4.76% X 115% = 1558(SP500 prediction with market psychology being positive)

With the current level of the SP500 representing about $10Tril, it becomes a simple process to make the estimate of ~$4Tril potential capital additions to achieve the SP500 1500 range.

One should note that with the Market Capitalization Rate at 4.76% that 10yr Treasuries at 3.4%-3.5% are 36%-40% over priced and in what Warren Buffett described some time ago as a “Bubble”.