International Interests: DXY and EURJPY

The DXY traded near multi-year lows on Friday’s weak jobs data. This move opens up the trap door scenario we are looking to drive a major low in the greenback. Look for further weakness as we approach the 9/18 FOMC meeting where the market will be looking for 50bps ease. If the Fed holds the line it could be off to the races.

The EURJPY remained under pressure this week and traded on cue with other risk markets this week. The pattern is unclear but it seems we are consolidating a range. How we break out in the coming days could drive the larger trend. By the looks of it the break could be higher.

Cost of Capital: 5YR Treasury

The 5YR note traded to a low yield of 4.00% this week as traders began discounting a Fed ease and further deterioration in the economy. A further decline in yields is ominous for the economy and other assets as the market has been very precise in forecasting the rate of growth. The market is calling for an ease but I doubt they get more than 50bps by the 9/18 meeting assuming no unforeseen crises driving an inter-meeting ease. We should keep a close eye on the front end of the curve. If the curve is trading steeper assume risk aversion. If the curve is trading flatter then risk is being placed.

Beta Maximus: ESU7

Equities pulled back this week as thin volume and scaled buyers allowed the market to drift lower into the weekend. The weaker jobs data was the catalyst that broke out of the tight range built in previous sessions but I have to say the selling was rather orderly as it has been for much of this correction. We think the market could grind higher into the Fed meeting but with the rapid deterioration in the jobs data we would not be aggressive buyers until another successful retest of the 1375-1360 area.

Duke & Duke: GCV7

Gold popped back above the $700 level on a flight to quality and Fed ease discount. It remains to be seen whether we are vaulting from here or whether we saw an oversold bounce. We find it difficult to believe gold will out perform during a collateral liquidation and are not buyers in this environment.

Ex Ante Factor: Flight to NDX – Revisited

Friday’s dismal jobs report hit cyclicals hard as the market came to grips with decelerating economic growth. Despite positive retail same store sales comps, consumer discretionary stocks actually were hit the hardest as the market looked to discount a consumer pullback. Two market leaders we have been watching, tech and materials were also among the worst performing sectors down +2%. The more defensive sectors such as utilities, health care and consumer staples were the best performing.

Despite Friday’s steep sell off, large cap tech stocks continue to lead in this year’s highly volatile environment. Year to date the NDX is +11.5% v SPX +2.5%, DJIA +5.25% and RUT -1.5%. In the 7/28 chart of the week we cited this out performance, specifically noting: It is my contention that while large cap tech still got hit, the risk-adjusted out-performance suggests, due to their solid liquid balance sheets, some smart money might be buying this sector as they rotate out of levered sectors. Many of these companies are too large for private equity to LBO, especially with the cost of their leverage rising so fast. A favorite tool of activist hedge funds, the leveraged stock buyback and dividend payment is going away for the same reason (see EXPE and HD buyback news). The seemingly stubborn reluctance for these tech companies to spend their cash ironically may now be catalyst that draws investors seeking liquid balance sheets.

When liquidity gets tight, those that own liquidity are best positioned to take advantage of the squeeze or potential de-leveraging that occurs during the cycle reversal. Large cap tech titans AAPL CSCO GOOG INTC MSFT have a combined market cap of $890b. Only CSCO and INTC report any debt outstanding at $6b and $2b respectively with the others reporting no debt. The combined cash on the balance sheets is approximately $80b with CSCO and MSFT carrying roughly half of that at $20b each.

This week INTC (ytd +27.75%) disclosed a 2.5% stake in VMW, the EMC spin-off that is +140% since the IPO in mid-August (INTC’s cost basis is +200%). I think this is just a taste of what’s to come as these liquid tech companies opportunistically deploy cash at relatively cheap valuations. Obviously we would expect them to target their own sector but also possibly other sectors such as communications, financial services, manufacturing, media, transportation, and even energy. An example of sector leaders whose market caps are within striking distance of the cash levels of our tech titans are MOT ($40b), BSC ($16b), MMM ($65b), VIA ($27b), FDX ($34b) and DVN ($35b). These tech leaders could emerge as the next generation of conglomerates.

During a credit crisis, like the one we are experiencing, money seeks liquidity. In the 7/28 article we also cited BRK (+8.6% since the article) as a cash ginning machine and beneficiary of this flight to cash. Warren Buffet is perhaps the king of liquidity and it’s no surprise that investors seek his balance sheet during credit turmoil. He and Bill Gates have become close friends and allies, with Gates on the Board at BRK. It’s no coincidence their companies operate two of the most liquid balance sheets and MSFT could be poised to follow in BRK’s acquisitive footsteps.

We aren’t suggesting that large cap tech will rally if the overall market is for sale. They carry a high beta which elevates their risk during increased market volatility and are highly cyclical which place them at risk during an economic slowdown. However, we do think this coming market cycle will be more about de-leveraging and contracting balance sheets among financials which represent 20% of the SPX. Sectors relying on leveraged capital spending like industrials and materials could also suffer. Look for the market to concentrate less on low P/E and leveraged ROE and more on low Debt-to-Capital and high ROIC. Cost of debt capital is rising rapidly and those capital structures weighted with debt are likely to see their ROIC-WACC spread shrink. Companies that issued debt to buy back stock are especially vulnerable in this scenario as their arbitrage spread has been removed and reversing.

What is the Discount?
Risk assets continued to under perform this week with the implied equity risk premium shot up 29bps to 3.41% representing some of the best relative value for the year. Investors piled into the treasury curve on the weaker than expected jobs data and are now discounting further deceleration in growth. With the markets in price discovery mode we believe there will be plenty of expansion and contraction of spreads in the coming months. This widening should continue but we would expect value buyers to come in and nibble at equities at this relatively cheap valuation v treasuries. You are currently being paid 50bps to hold equity paper which is half the spread paid during the March correction when equity discounts were trading +100bps over debt.

Bottom Line: The market is likely in for a bumpy ride over the next few months but we think the large cap tech relative out-performance is here to stay and recommend a substantial exposure to this sector for long equity allocations due to their highly liquid balance sheets and thus competitive advantage as credit risk is being re-priced.