Andrew Dalton On The Markets

As someone who is required to read a huge amount of written material about investment, I have spent many years looking for experienced professionals who can write both clearly and with integrity about the the changing dynamics of the markets. By that I mean experts who are not just easy to read and understand, but who have the judgment and experience to be able to distinguish between “noise” and substance – to pick out what matters from the daily torrent of information and data that is now available to all market participants courtesy of Reuters, Bloomberg, the Internet and traditional news media.

One of the few who meets this demanding set of criteria is Andrew Dalton, who spent 30 years as one of the key senior management team at Mercury Asset Management before setting up his own fund management firm, the Dalton Strategic Partnership, seven years ago. He is going to be contributing his weekly market reports on a regular basis in future for Independent Investor. This is his take on the events of the week ending 7 March 2010.

The rally which began in mid February has continued last week. The pressure associated with Greece lifted slightly. The Greek government completed a €5 billion bond issue, albeit at 35bp of yield above the market. This provided modest relief to the Euro on Friday. From a technical point of view, equity markets maybe slightly over-bought on a short-term basis. However, there has been a notable decline in selling pressure over the last three weeks, together with signs of greater buying power.

Markets have broadened, particularly in the United States, where it is now clear that mid cap and small cap indices are above their early January highs, even if the S&P itself is not yet there. Economic statistics, coming out of the US have been complicated by severely bad weather conditions in February. Nonetheless, the US Federal Reserve Beige Book gives some comfort that economic conditions continue to improve albeit at a relatively gentle pace.

The US non manufacturing ISM index rose to 53 in February, which was above consensus expectations. The details included solid gains in the employment and new orders components. The ISM indices typically are not particularly susceptible to storm related distortions, which are likely to have a bigger impact on payroll and consumer spending data.

Reports from the 12 US Federal Reserve districts contained in the Beige Book indicated that while economic activity remains at a relatively low level, conditions have improved modestly since the last review and those improvements are broadly spread geographically than in the last report. Ten districts reported some increased activity or improvement in conditions, while the remaining two reported mixed conditions. In the last Beige Book eight districts had reported increased activity or improving conditions. Most districts reported that consumer spending in the recent 2009 holiday season was slightly greater than in 2008 but still well below 2007 levels.

Retail inventory levels remain lean in nearly all districts. Auto sales held steady or increased slightly since the last Beige Book in most districts. Non financial services activity generally improved in districts that reported on this sector. Manufacturing activity has increased or held steady since the last report. Among districts reporting on near term expectations, the manufacturing outlook was optimistic but spending plans remain cautious.

This is all good news from the equity investor’s point of view – a positive story but not overblown. There is still enough weakness to reassure the banks that interest rates are not likely to go up soon. Towards the end of 2009, home sales increased in most districts, especially for lower-priced homes. Home prices, this time, appear to have changed little since the last Beige Book and residential construction remains at low levels in most districts. Commercial real estate was still weak in nearly all districts with rising vacancy rates and falling rents.

In essence this reaffirms that while there are clearly some divergences of opinion between FOMC members, the Fed will not feel any pressure to tighten policy or withdraw liquidity (beyond what is already scheduled). Elsewhere, notwithstanding the strength of the Japanese yen, Japanese exports are recovering quite sharply. Japanese exports have risen 46.8% from a year ago while imports are up 34.7%. The trade surplus in February was ¥99.4 billion, up from a deficit of ¥141.5 billion a year earlier. On a seasonally adjusted basis, exports have accelerated steadily from 0.6% growth (a month) in July last year to a record 8.6% month-on-month rise in January. Meanwhile, the Japanese stock market is cheap still.

The problem is to identify who will be the buyers. In Japan, foreign investors were net buyers of Japanese stocks for the third week in a row last week by a ¥82.5 billion margin (down from ¥100.5 billion the week before). Japanese trust banks, though, were net sellers of ¥86.6 billion shares. Individuals were net buyers but only by a ¥1.0 billion margin, although this compared to being net sellers of ¥49.0 billion the previous week. The press commenting on the Japanese Ministry of Finance’s latest corporate statistics report are still pessimistic and focused on the weakness of current corporate fixed investment spending instead of the 102% rise in profits. In fact, Investment spending has fallen 17.3% from a year earlier.

Our guess is that it will pick up. Anyway, Japanese corporate profits bottomed in 2009 January to March quarter, albeit at a historically low level. Looking at the four previous corporate earnings upcycles excluding the current one), on a simple average basis they have lasted 13 quarters, which suggests that the recovery will continue quite some more time. Capital expenditure has continued to fall but, historically, capital expenditure bottoms out approximately six months after capacity utilisation bottoms out, which has already happened. We remain modestly positive about Japan.