Top-Down Storms Imperil Bottom-Up Optimism

July 20th, 2010 | by Jaxon Hewlett |

“Bottom up” investors have grown excited in recent days by strong corporate reports like Intel’s. But “top down” considerations, with an especial focus on consumers, banks and the U.S. housing market, still look ominous.

In a book called The Research Driven Investor – now out of print – Timothy Hayes describes the market as a giant mountain. The purpose of this metaphor is to help distinguish between “top down” and “bottom up” investing and trading disciplines.

In the market-as-mountain metaphor, bottom-up investors are like hikers and climbers starting at the base of the mountain. Their main focus – individual companies – is akin to examining the rock formations and terrain directly in front of them.

The top-down approach is different. Rather than starting with on-the-ground conditions at the base, top-down analysis begins well above the mountain’s peak. As opposed to individual companies, the top-down analyst is more focused on “general conditions”… the ebb and flow of credit, risk appetite, economic weather patterns, and so on. One could picture this as a 10,000-foot view, or even a 40,000-foot view, in which grand sweeping trends are the main consideration.

During periods of relaxed prosperity, bottom-up investors can more or less ignore the top-down inputs, much as mountain climbers can feel relaxed when the weather is warm and the sun is shining.

But when the thunder is rumbling and the lightning is crashing, top-down considerations become much more important. Under those conditions, the bottom-up investor has to be wary of what comes from above… lest an avalanche, a lightning strike, or a full-force gale wreaks havoc on the portfolio.

Right now, the markets are extremely volatile due to mixed signals. Bottom-up investors are uncovering reasons to be bullish via positive corporate earnings results – such as Intel’s record revenues – while top-down analysts and traders see a much darker picture.

A Call for Dollars

One top-down analyst who captures this split succinctly is John Taylor, the founder of FX Concepts LLC. If the well-known Bill Gross of PIMCO is “the bond king,” as the financial press has nicknamed him, then John Taylor might be dubbed “the forex king.” FX Concepts, which Taylor founded, is one of the oldest and largest pure currency hedge funds in the world.

In a recent note to investors, Taylor had this to say (underscore emphasis mine):

… The increase in corporate earnings and the projection of further increases seems to be universal, and many argue that the positive outlook for thousands of individual companies must sum to an impressive economic recovery.

Despite these positive micro stories, they do not add up to a happy macro outcome. There are several reasons why this is the case, but the result is that the vast majority of the analysts that examine individual companies are bullish and almost all of the macro analysts are bearish, many like us, and dramatically so…

… With the global banking system suffering under an extremely high load of worthless assets – whether recognized or not – and being forced to improve their capital allocation for risk by the Basel II and Basel III rules, banks must cut back the amount of credit that they make available to the economy. The multiplier will force global economies to shrink in the years ahead. Cash is now king, worthless or not, so buy dollars.

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In the equity markets we have seen this micro/macro split play out with a major divide between the “haves” and “have nots.”

In terms of earnings and profit projections, the “haves” are companies like Intel. These well-capitalized players are by and large sitting on significant cash reserves, and have benefited handsomely from the Wall Street revival of corporate credit.

The “have nots,” unfortunately, are a much larger group overall, including U.S. consumers and small businesses. And so, while bottom-up analysts have been able to cheer the finance-led revival of select blue chip names, top-down analysts have looked on in horror as U.S. consumer finances continue to deteriorate and small-business prospects continue to look bleak.

John Taylor’s decidedly 40,000-foot view – “Cash is now king, worthless or not, so buy dollars” – is based on the deflationary notion that global credit will contract even faster than the Federal Reserve and other central banks can inject fresh liquidity into the system. When this happens, demand for dollars outstrips supply as non-dollar-denominated investments are cut back or abandoned.

Killing the Weak Recovery?

As fresh signs of deflation show up in closely monitored areas like consumer spending, small-business conditions, and the state of the U.S. housing market, commentators like Paul Krugman, Ambrose Evans-Pritchard and Martin Wolf are ratcheting up signs of alarm that a new commitment to government “austerity” may be dangerously harsh medicine at the wrong time.

The fear is that tightening up on the reins now will reproduce the equivalent of Roosevelt’s big mistake in 1937, to wit, shifting back to a tightening stance too early and thus killing off the recovery.

Other market observers, like John Mauldin, are deeply concerned that the scheduled repeal of the Bush tax cuts – which will have the same effect as a sharp tax hike – could have the result of pushing us back into recession at a most inopportune time.

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What’s more, all of this is overlaid with extreme political weakness in the White House, as support for President Obama and his policies hits new all-time lows (even among Democrats). From a political gamesmanship perspective, ebbing support for the White House means even less chance of new stimulus measures getting through.

Those highly skeptical of the stimulus efforts will argue any new outlays would be throwing good money after bad regardless – what good is stimulus that doesn’t actually stimulate? – but what Wall Street will see is gridlock where once there was unity (in terms of economic rescue efforts) and the inability to commit to substantial new stimulus funds.

(If you would like to read more of Justice Litle’s investment commentary on other topics, sign up for Taipan Daily.)

Why the Intel Rally Foundered

As of this writing, the “Intel rally” from earlier last week has given up the ghost. The major indexes have been decisively repelled at the top of their channel trading ranges. Investors who wonder at this result – How can the market be so weak when corporate results have been strong? – should consider the wintery bleakness of the “top down” picture.

Consumers spending still represents 70% of U.S. economic output. Small businesses still account for more than half the U.S. economy and, by some measures, virtually all the net job creation. What’s more, the U.S. consumer has even more powerful reach by way of supporting the rise of China and other rich world dependent exporters.

And so, due to ongoing consumer weakness, ugly housing market tells, and the still precarious nature of the banks – both in the U.S. and elsewhere, Europe first and foremost – bottom-up investors must remain prepared to weather severe economic storms.

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