Looking for gas in the Industrials' tank

I don’t understand what part of the puny 10% of $787 billion in stimulus spending plan outlay for infrastructure went unnoticed. The reason I say that is because I find it perplexing that Industrials, which is one of only three S&P 500 sectors (Energy and Materials are the other two) where EBITA recovery has consistently lagged the broader market in last 4 recessions, has already outperformed the S&P 500 by more than 2x it’s relative outperformance in the 4 quarters following the 1Q03 bottom, for absolutely unknown reasons.

What is causing a typical earnings laggard sector like Industrials, which comes with relatively rich valuation, and lower international exposure and leverage than the broader market, to outperform the market ?. Typically, reflation trades are based on the belief that assets whose current earnings power is most depressed should trade ahead of their historical relative valuations - One can note that any sector whose relative earnings power (current earnings contribution to the benchmark vs. in say 2006) is lower, now commands a higher relative valuation vs. it’s historical valuation vs. the benchmark (see Exhibit 1). While that trade may make sense for certain sectors, it has likely been overdone (at least since the March bottom for equities) in certain sectors such as Materials and Industrials, with Industrials a rather strange beneficiary. Industrial stocks now trade at close to 10% premium over the benchmark (vs. a historical high single-digit discount), even as their relative earnings contribution to the benchmark isn’t particularly depressed (current contribution to benchmark earnings is just about 4% shy of 2006A levels). Coupled with the fact that Industrials consistently lag the market in EBITA recoveries and provide relatively lower optionality for earnings upside (lower international exposure and leverage vs. the market), there is little to support the recent outperformance of Industrials.

Exhibit 1 – Analyzing how “reflation” trade has worked across sectors

* Relative implied pessimism is an absolute metric, which measures change in sector’s earnings contribution to benchmark vs. change in its relative value – The higher the better; ** EBITA is used as a metric to neutralize financial leverage effects while accounting for differentials in fixed-asset intensity; No sector has shown consistency in leading EBITA recoveries; Materials, Energy and Industrials have consistently lagged.

Source: S&P, Mckinsey & Co., Reuters, Internal Analysis & Estimates

I don’t see any credible evidence to support why 2010E estimates for Industrials could be viewed as relatively low vs. the broader market. In line with its consistent tendency to trail earnings recoveries, 2010 earnings growth expectations for Industrials are lower than every sector, except Telecom Services. To put things in context, in 2003 (the year of market bottom, which followed the earnings bottom at the end of 2001) Industrials posted a low single-digit earnings growth, well below the close to 20% earnings growth for S&P 500. In fact, it wasn't until 2005 that Industrials earnings began to outpace the broader market. For 2010E, estimates suggest high single-digit earnings growth for Industrials vs. 30%+ growth for S&P 500, which is largely driven by Financials, Energy, Materials and Consumer Discretionary.

Recent earnings performance hasn’t produced anything to support the relatively depressed estimates hypothesis – Just under half of S&P 500 companies beat earnings estimates by more than 5% in 2Q09, just ahead of Industrials’ 47% (see Exhibit 2). Further, only about a fourth of Industrials matched or exceeded revenue expectations, compared to 35% of S&P 500 companies.

Exhibit 2 – % of companies beating consensus earnings by >5% in 2Q09

Source: First Call

Note: Telecom Services’ performance may not be statistically significant. Only 9 companies comprise the sector in S&P 500, one-third of the second smallest representation, Materials.

This is purely a quant exercise to screen sectors for systemic protection (potential shorts). For the most part, this wasn’t meant to be a judgment on published estimates. It is rather an assessment of the first derivative – Are valuations appropriate, assuming that estimates, which are rarely right going into declines and off of recoveries, happen to be spot-on.



DISCLAIMER: The information, opinions, estimates and projections contained in this post were prepared by me and constitute my current judgment. The information contained herein is believed to be reliable and has been obtained from sources believed to be reliable, but I make no representation or warranty, either expressed or implied, as to the accuracy, completeness or reliability of such information. I do not undertake, and have no duty, to advise you as to any information that comes to my attention after the date of this post or any changes in my opinion, estimates or projections. No part of this post can be reproduced without permission, unless reproduced with due credit provided for the source. Investment research is provided for information purposes only and does not constitute investment advice or an offer or solicitation to buy or sell any designated investments discussed herein. Please discuss with your investment advisor before investing.

Cumulative Performance [thru mid-August 2009]

Note: CS-Tremont AllHedge performance for 1H of August 09 is not yet available.

Since inception in mid-08, Contravest has outperformed CS-Tremont AllHedge, Russell 2000, S&P 500 and Barclays Global Bond Aggregate by 29, 43, 41 and 15 pps respectively*. Contravest was up 4.5% (unlevered) in 2008 and remains up and ahead of all benchmarks and most peers in 2009 YTD*.

* as at the end of trading on 08/17/09. Comparison vs. CS-Tremont AllHedge is as at the end of July 2009.

Disclaimer: Performance figures are for informational purposes only and do not constitute investment advice or an offer or solicitation to buy or sell any designated investments discussed herein.

House prices – Is this the inflection point ?

Is it realistic to expect that Case-Shiller’s May report from earlier this week could indicate an end to house price declines ?. I was surprised that a high number of market participants viewed that as a sign of stabilization, despite an increasingly worsening inventory and a pull-back from first-time buyers.

Housing inventory is likely getting more distressed. The chatter around bulging “shadow inventory” isn’t one that could be out rightly jettisoned. Despite rising foreclosure activity (Almost 900K filings were reported in 2Q09 vs. under 750K in 4Q08), it’s worth noting that distressed sales have accounted for fewer home sales recently than at the beginning of the year (see Exhibit 1). It is likely that an increasingly smaller portion of distressed homes is showing up in the listing. Concomitantly, a relative lack of first-time buyers (whose focus has largely been on distressed transactions – see Exhibit 1) is lowering the concentration of distressed transactions in existing home sales figures. As a result, the “real” housing inventory has likely gotten more distressed than at the beginning of the year.

Exhibit 1 - Concentration of distressed sales and first-time buyers – Last 5 Months


Source: NAR


This isn’t a time to chase rental yields. Despite rental vacancy rates reaching all-time highs, asking rents have kept “relatively” steady even though rent growth is expected to remain flat this year (see Exhibit 2a). As a result, improved rental yield spreads are attracting repeat buyers in the market. On the other hand, participation from first-time buyers has suffered, following an initial spurt in response to the announced tax-credit. In June, first-time buyers accounted for under 30% of the transactions, down from 50% at the beginning of the year, 40% in June last year and a more normalized level of about 40%-45%. At this point, there is simply not enough interest from first-time buyers to fully support “move-up” of current owners.

Exhibit 2a – Rent Growth vs Rental Vacancy Rate














Exhibit 2b – Rental yield spread* vs Home Prices


Source: Census Bureau, Freddie Mac, S&P
* Rental yield spread is calculated as rental yield less tax-adjusted FRM interest


It’s hard to reconcile with the logic of chasing rental yields in the current environment – Rental yield spread over tax-adjusted FRM is barely above historical averages (see Exhibit 2b above) and even though that may begin to look attractive to some, there is enough evidence to suggest that asking rents could fall while mortgage rates are unlikely to - Rental vacancy rates are near all time highs, job losses continue, re-modeling costs are down and there is barely any (or prospect of any) wage inflation in the rental and leasing industry. That’s not all – If the MID cap comes down to 28%, rental yields could depress further.

To summarize, increased participation by first-time buyers is needed not only to absorb current REO inventory but also to support move-up of existing owners, which is the only way that housing sales mix will sustainably drive home prices higher. As things stand, any short-term stabilization will likely only signal a hiatus and not an inflection point.



DISCLAIMER: The information, opinions, estimates and projections contained in this post were prepared by me and constitute my current judgment. The information contained herein is believed to be reliable and has been obtained from sources believed to be reliable, but I make no representation or warranty, either expressed or implied, as to the accuracy, completeness or reliability of such information. I do not undertake, and have no duty, to advise you as to any information that comes to my attention after the date of this post or any changes in my opinion, estimates or projections. No part of this post can be reproduced without permission, unless reproduced with due credit provided for the source. Investment research is provided for information purposes only and does not constitute investment advice or an offer or solicitation to buy or sell any designated investments discussed herein. Please discuss with your investment advisor before investing.